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Avalon Asset Management Company Too Pig to Bail
"Well I'm stuck in the middle with you, and I'm wondering what it is I should do." - Ken Urban
This is the current state of the stock market: if the S&P should drop a hundred points lower, then everyone is ready to be a buyer (or so they think). If the S&P should move a hundred points higher, then everyone is ready to be a seller. The problem is deciding what one does in the meantime.
The answer for now, it seems, is to hedge. Or should we say waffle? Buy put contracts, sell futures, keep your longs. The all-important end of the quarter is only seven trading days away, but for many it’s an eternity. Sell now, and one might miss that breakthrough rally up to 1000, even 1050. But the data and earnings aren’t so hot, so better take on some extra downside cushion, just in case we hit another air pocket. And so they stay in the game, eyes on the other players, cards clutched to the chest, too scared to trail, too pig to bail.
Why should the market go up? Well, you know, lots of cash on the sidelines, potential chart breakout, lots of stimulus, recession has to end sometime, (notice the lack of talk about growth). So why not buy? Well, you know, rising unemployment, declining spending, corporate outlooks are pretty gray. So sell – but then you might miss the quarter-end markups, or even the rally that Byron Wien is talking about - he says the S&P is about to go to 1250. But doesn’t Marc Faber say the market is about to take a tumble? It’s all so complicated.
We wish that we could tell you which way the market will break. Last week we weighed in ever so slightly for an upside breakout, along with the scarred warning that such talk usually guarantees the opposite. Monday we were treated to a triple-digit drop that managed to outlast the rest of the week and break the market’s winning streak. Nevertheless, it didn’t break out to the downside either, with the S&P bouncing nicely off its support lines and finishing within easy distance of this year’s high.
Traders were supposed to fear a deregulation speech on Wednesday, but Obama, Geithner and Co. aren’t really interested in frightening the horses these days. By week’s end, the proposals had faded from thought on the Street, with the politicians lined up in predictable fashion on either side of the Fed: too much power, said the right, not enough punishment, said the left.
Sens. Shelby and Shumer played well to their respective audiences, with Shelby hamming up the role of stern traditional Southerner, suspicious of them Ivy-league Washington varmints (think Lionel Barrymore, Jr.), while Shumer played the suave and reasonable New Yorker (the late Phil Hartman, we think, or perhaps Peter Lawford).
When Congress chewed over the too-big-to-fail conundrum with Treasury Secretary Geithner, we couldn’t help but reflect on how much things have changed this decade. In the 1980’s, the prevailing thinking was that American banks would be eclipsed by their larger Japanese rivals. When that country’s bubble blew up, the fears moved to European universal banks. Then our investment banks went public, and by the middle of this decade most were on an acquisition spree partly fueled by the mantra, get bigger or get eaten.
The financial supermarket model was tried in the eighties and didn’t work. Ditto in the nineties, and you know how it turned out in this decade. The cycle has ended for now, but it’ll be back someday. Contrition is the new name of the game, and its uniform sackcloth and ashes. Or something in a stripy theme, perhaps, as a certain Mr. Madoff is scheduled for sentencing on June 29th, when he will be assigned a new wardrobe and mailing address. The SEC officially enjoined him from working in the business anymore last week. Feel safer now?
The debate on the proper role of the Fed and its conduct during last year’s meltdowns featured earnest talk about how important it was for Treasury and the Fed to have specific take-over powers during times of systemic crisis. When the rules were first written in the nineteen-thirties, lawmakers who were mindful of a tidal wave of financial failures threw in a deliberately vague emergency clause that would let the Fed do what it thought it had to do if things got rough enough.
That rule was good enough to allow Bernanke and Paulson to engineer the handover-sale of Bear Stearns to JP Morgan (JPM) in March of 2008. But it wasn’t good enough to withstand criticism from an influential laissez-faire wing ready to march us over the falls, if necessary, to prove the admonition that all government is evil (they’d have spared themselves, of course). Bernanke’s defense was to frequently lament the lack of a specific recipe for bank rescues (take one toasted investment bank and pluck its executives thoroughly. Then grease a Senate broiling pan, etc). In New York terms, whaddya want from me?
When banks started coughing up blood in September, our two money chiefs were wary of getting beaten up anymore for bailing out Wall Street big-shots, and decided that saving Merrill Lynch while letting Lehman go would be enough. Oops. We’ll give Paulson credit for reversing course as soon as the disaster became apparent (Bernanke deferred to him all the way on this one, we are sure), but the damage was done.
So Geithner and the administration make the requisite, backward-looking fuss over structures, but the latter aren’t the issue. It’s the specific people in charge that matter. Greenspan had too much faith in the discipline of the markets (probably because for most of his career, investment banks were partnerships), but we don’t believe for a moment that he’d have let Lehman go. He was too much of a market guy to let that happen.
On the other hand, Bernanke has shown great creativity and skill in steering the Fed through the role it was created for: to save the system from melting down during a panic. Very few appreciate how close we came to a genuine catastrophic collapse of the entire financial system. When the next crisis arrives, the rules won’t matter as much as what the people in charge want to do. The Fed didn’t have to pull reserves out of the system in 1937, but they did. Wrong move.
Bernanke & Paulson could have invoked another emergency and backstopped Lehman, but they didn’t. Had a specific structure been in place for doing such things, Bernanke would probably have stepped in and no doubt he will if he’s around again for the next one, but that’s too far off (we hope). Greenspan would have backstopped a rescue, but Volcker wouldn’t have let the banks get so levered up. Maybe the chairman twenty-five years from now will try to teach the bad boys a lesson and plunge us into a deeper crisis.
When decisions are made out of deference to a credo over how the world ought to work, disaster looms. Consider Moliere’s doctors, who combined complete allegiance to the dogma of the medical academy with total indifference to the fate of their patients (the doctor followed their commandments, and after that it was up to the patient to get better or die. Sounds familiar).
Many today don’t want the Fed to succeed in its easing policies. Some fear to tarnish the image of monetarism, others a violation of hard currency standards, and many a lemming will go to the grave slavishly believing that any governmental intervention in the markets is a sign of the apocalypse. As Alexander Pope so accurately observed, “a little learning is a dangerous thing.”
All this can make things pretty confusing for the public, as evidenced in polls released last week showing deficit fears creeping to the top of the list. At some point the central authorities will have to bring Treasury borrowing and Fed monetization to the top of the list of things to worry about. They know it, and we know it.
But that day is at least two or three years off. It won’t be Fed magic that keeps us from inflation, but an economy that is going to be limping for a long time. Our descent into the maelstrom may be about over, but the chapter following stabilization is going to be called stagnation. We are nearly out of the recession, but a long way from being out of the woods.
The 1980-82 recession was a classic industrial squeeze, brought on by the Fed choking off the money supply to kill inflation. The manufacturing sector that bounced back quickly then is a much smaller part of the economy now. There will be no decades-long easing of interest rates and inflation to increase the value of asset prices, no TEFRA to begin sucking money into the stock markets.
The 1990-92 recession was brought on by another financial crisis, the savings-and-loan/junk-bond debacle. The jobs recovery was much slower that time. The current financial crisis is much bigger, with manufacturing smaller than ever. Excluding health care and government, most of the jobs created out of the “jobless” 2001-2002 recovery derived directly or indirectly from the real estate and credit bubble. The odds of getting any bubble in the next few years are zero.
But wait – what about all that cash on the sidelines, and the Chinese looking at some bottom-fishing with hedge-fund investments? Sovereign wealth funds to the rescue? That bit of nonsense was hot stuff back in the summer of 2007, along with the notion that the retail investor was going to come into the market and drive it higher. Uh, nope. The appeal to sovereign wealth funds resurfaced in March 2008 in the wake of the Bear Stearns collapse. Oddly enough, it still failed to revive the market, nor did the retail investor.
Yet do not worry, fellow investors, for there is yet money to be made. Barring political shocks, a bounce in economic statistics is imminent, and fourth-quarter earnings comparisons are a lock to appear wonderful. Both episodes should be a big adrenaline rush for equity prices, even if the real economy will be essentially going nowhere. Just remember the old Wall Street saying: bulls make money, bears make money, but pigs get slaughtered.
One would think that if there was any unequivocal news on the economy during these murky times, it was on inflation last week. Both the CPI and PPI fell, as measured on a year-on-year basis, with the former posting its weakest result since 1950. The monthly changes of 0.1% in the CPI and 0.2% in the PPI (with the core rate in the latter falling 0.1%) were much weaker than expected. Allowing for an uptick this month from the rebound in energy prices, inflation nevertheless appears to be dead for now. Doesn’t it?
Not if Moliere’s doctors have anything to say about it. The Fed may be breathing easier, but market commentators were mostly skeptical. One wag was quick to point out that the previous low in April of 1950 was followed by 7% inflation a year later (it won’t happen this time – unemployment was at 3.5% back then). Others invoked the period of the late sixties and early seventies, when the attempt to have it all fiscally and monetarily ended in inflation.
Dr. Milton Friedman’s name was widely and mistakenly cited to assert that the syndrome (current Fed policies) must inevitably lead to death (inflation). The names of such diseases as the Weimar Republic and Zimbabwe are being darkly repeated (i.e., hyper-inflation episodes), along with the usual grim beard-tugging and head-shaking. Some wags go so far as to say that we are now certain to have inflation, because the current deflationary data will only encourage the Fed’s nefarious ways. Ergo, the more deflation we get, the more it is really inflationary. The doctors would be so proud.
The economy does what it does without listening to advice from doctor-ideologues about what it ought to do. Things are too weak for demand-pull inflation and the situation will remain so at least through the end of 2010. The cost-push inflation of the 1970’s will not be reproduced either, because that decade was the last one to see national wage bargaining as a force. There will be no wage-price spiral this time.
The nearest danger on the inflation horizon is commodities. With fourth-quarter earnings comparisons certain to be positive after last year’s train wreck, the ensuing excitement, however ill-founded, will lead to another flood of money rushing in to make bets on commodities. We’ve already had the first surge.
The flood tide will be attributed to the Fed’s policies – it already has been – though the central bank’s policies will have had very little to do with it. Banks aren’t about to use reserves to make loans to hedge funds or commodities speculators. The money hasn’t come into the system from easing, though easing has helped keep it from disappearing.
No, that money is already here and waiting on the sidelines for something to do. Much of it will flow into equities when the comparisons turn positive, but being much larger, those markets are much better placed to absorb it. They’ll go up, but for the smaller commodities markets, it’s going to be like rocket fuel.
Last week’s Wall St. Journal carried an article on one Mark Spitznagel, a hedge fund manager who made a killing last year on the market collapse. Mr. Spitznagel, it seems, is preparing to put a multi-billion dollar bet this summer on big increases in inflation. He will do so chiefly by buying options on commodity contracts. The dealers who sell those options will in turn hedge their exposure by buying contracts in the futures markets, thereby driving up commodity prices.
That should whip up Fed-blaming inflation talk and give the central bank a headache. If the economy continues to slog its way along as we suspect it will, however, prices will settle down again. Indeed, the rise in commodity prices could carry the seeds of their own destruction: higher prices cut into real income, which is getting no help at all from the labor markets.
Those labor markets will be softening into the middle of next year. Last week’s claims report was about even with the week before, gaining its usual comparative benefit from an upward revision to the previous week. The press eagerly lapped up the story that continuing claims fell for the first time this year, although that story was reported a few weeks ago and then revised away a week later.
A weekly claims rate in excess of 600,000 is very high, but may not be high enough to keep the continuing claims number moving higher. The result won’t be revised away this time, for the simple reason that after six months, unemployment claims expire. Layoffs started in real quantity in the fourth quarter of last year, and now those claims will start to exit the count. The good news is that federal emergency benefits cover an additional 26 weeks, but those claimants aren’t counted in the continuing claims total. Although there aren’t any less people out of work, fewer people are counted on the state rolls.
Weekly claims will stay under pressure this month from the auto sector, though other sectors are subsiding. As we’ve been saying, a pause in factor cuts is inevitable. Continuing claims should drop irregularly because of the accounting fiction described above, but that has no effect on rising unemployment. A further statistical benefit will come from Chrysler’s announcement that it will resume output at seven plants this month, but keep to its summer schedule of two weeks of plant closures in the middle of July. That will take more people off continuing claims, yet the two-week layoff won’t qualify idled workers for new claims.
There was some housing news that the markets quickly forgot, and for good reason. What was surprising was not that starts rose – after all, they are at record, unsustainably low levels – but that the markets paid so little attention to it. The housing market index, which is the homebuilder sentiment survey, reported a small decline where a small gain was expected, so that helped keep a lid on things.
Nothing has changed, though. Homebuilding is in a bottom and will stay there the rest of the year. The numbers are so low right now that small changes mean exaggerated percentage moves, but are just so much noise. Next year will hopefully be different, but this year is about survival.
We’ll get the rest of the housing picture next week with existing home sales on Tuesday and new home sales on Wednesday. Both are predicted to pick up two or three percent, leaving plenty of room for upside surprise from very low levels. Yet mortgage-purchase activity remains quite anemic. Refinancing activity has fallen off sharply the last four weeks, with higher rates getting most of the blame. Rate increases are undoubtedly a principal factor, but it may also be that the pool of qualifying applicants just isn’t that large.
The nation’s output picture was about what our readers should expect. The New York Fed’s June survey showed a pickup in the rate of decline, albeit a mild one, from (-4.6) to (-9.4). A small improvement had been expected, and the Monday disappointment helped take the market down that day.
The Philadelphia Fed, by contrast, showed a marked improvement in its rate of decline, recovering from a steep (-22.6) to a nearly-neutral decline of (-2.2). The central bank’s industrial production measure for the previous month of May, though, showed another decline of 1.1% as capacity utilization and manufacturing utilization again set new all-time lows, going back to 1967 and 1948 respectively.
That conforms to our picture of the mild inventory reload we’ve been predicting since the beginning of the year. We’re overdue for some kind of dead-cat bounce in industrial output and capacity utilization; it’s bound to happen within a month or two. We provide a note of caution, however, with the chart below of the Philadelphia survey:
Source: Philadelphia Federal Reserve
Optimists love to cite the increase in the six-month outlook these days, but as we never tire of pointing out, six-month outlooks are very good coincident indicators and lousy future ones (e.g., the Philly outlook twelve months ago). Looking at the chart, spikes in the six-month outlook are followed almost immediately by downturns in the actual number, with one exception: in 2004, it peaked several months before the downturn. It’s not science, but a month or two of positive numbers followed by another drop is consistent with past history and the current picture of a mild restocking. The “W” recovery view looks set to gain new adherents.
Keeping time, the Leading Indicators rose in May about as expected, 1.2% vs. 1.0% consensus. The increase was led by a widening yield curve, the rising stock market and the money supply, or in sum, the tail of the recovery rally. The report wasn’t as good as it looked – the drop in demand for long Treasuries was not universally welcomed, for example – and had little impact. The ratio of coincident-to-lagging indicators, thought to presage recession’s end, was even.
Next week brings the other big kahuna of economic releases, the Federal Open Market Committee (FOMC) meeting, after which the Fed will issues its monetary policy statement (fed funds target rate unchanged) and outlook (some signs of stability, with risks to the downside). Those predictions are easy enough, so market participants will be scouring the text for any signs of future tightening and any changes in outlook – last month’s report contained the usual text of some stability and hope, but slipped in some hefty downward revisions on the model outlook.
We doubt very much that the Fed will tighten this year, because conditions don’t warrant such a move. We doubt even more that the market’s chattering classes will stop talking about a potential tightening, because their jobs don’t warrant such silence. Yet the Treasury department is selling an awful lot of Treasuries these days, with lots more to come, so the topic isn’t going to go away.
Retail sales reports have been lousy all month, much worse than May, and while the exclusion of Wal-Mart (WMT) has an effect (it stopped reporting monthly data), the Fed can’t have failed to notice. Existing and new-home sales will be known before the statement, along with May durable goods and another weekly retail report. However, the personal income and spending report (along with PCE, the favored inflation index) will come later. Given the weakness in mortgage activity, the spike in yields and the supply of Treasuries, it seems to us that the Fed will be as unchanged as it can manage.
The final scheduled estimate for first quarter GDP is due on Thursday, with no change or impact expected. The last revision of first-quarter corporate profits will come out at the same time. Durable goods orders for May are expected to report a zag back down on Wednesday morning, while the income and spending report comes out on Friday. Both categories are expected to post an increase, but the range is very wide, with even purported consensus estimates varying. The University of Michigan releases its last June measure of sentiment on Friday morning, and is thought to show no change.
StockWatcher will return in a later edition.
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