Lexington, Massachusetts Investment Management
Lexington, Massachusetts Investment Management
Ill-met by June Light
“To show our simple skill, that is the true beginning of our end.” – WIlliam Shakespeare, A Midsummer Night's Dream
And to think that the week had started with such promise. The market was fresh from an options expiration week rally, leading to dreams of midsummer rally madness. The U.S. beat Algeria in the World Cup, leading to dreams of revenge on Ghana and a quarterfinal berth, while the U.K. bested Slovenia, leading the local football press to begin speculating about exactly how the Three Lions would take apart Germany, Argentina and Brazil.
But it was only an options rally, only Algeria, and only Slovenia. All of those hopes were dashed by the end of the week, a depressing result indeed (though perhaps less so for fans of Germany and Ghana). Fortunately for prices, though, Congress reached agreement on financial regulation on Thursday, setting off the expected relief rally in financial stocks, with accompanying short squeeze.
Looked at squarely, we would have expected a little more than a few points up on the S&P and a few points down on the Dow from the approval of the bill. That doesn’t bode so well for next week, though it must be said that we were also expecting the U.S. to beat Ghana.
Finally, we had a G-20 summit over the weekend, where the members involved agreed on a plan to cut deficits within a few years. The consequences of this momentous decision will probably affect markets around the globe for seconds on Monday, possibly even minutes. Given the consequences to Toronto (vandalism and riots), though, one would not be surprised to hear Baghdad proposed as the next venue.
A sorry May and a winding June have meant a lot of longer-term investors moving off to the sidelines in frustration. Many are ready to either buy below 1000 on the S&P or sell at 1200, but leave the terrain in between to the chart-‘em and churn-‘em crowd. Such sentiment will probably remain that way until earnings season begins in the middle of next month.
Until then, the market should set up in one of two ways. If the market can catch a little break from some of the early data next week, the usual push to mark up month-end and above all, quarter-end prices could get some traction. However, the markets would then be put to the test the last two days of the week, when a glut of economic data that includes the latest ISM release and the June employment report on the eve of a long holiday weekend could inspire a nasty bout of profit-taking.
If the market does sell off at the end of next week, it would probably refresh the downward momentum and set us up for a test of levels such as 1040, 1000 and possibly 950 on the S&P. We’d get a lot of talk of double-dip until second-quarter earnings begin. Since the earnings will be fairly good, the markets would then reverse in relief and probably keep on going through the month of August, a traditional month for momentum bulls.
If, however, the push higher were to last through the end of next week, then prices would probably keep rallying into earnings season in anticipation of the good results. Earnings will be the same in either case, obviously, but since the guidance will be mostly on the moderate to cautious side, should the market have rallied for two weeks in anticipation, it would then sell off hard. In that case August is a little harder to predict, but we would expect prices to start to climb again by mid-month.
Does all of that make sense to you? It probably shouldn’t, unless you’re a fulltime trader. Even then, it’s a bit lunatic, but sanity has never been a consistent winner at day-trading.
U.S. markets will be open all week leading up to the Independence Day holiday weekend, although you can expect the exodus from the major cities to begin around lunchtime, particularly in Manhattan. Since the next issue of MarketWeek will arrive in the midst of the long weekend, we want to take the opportunity now to wish our American readers an enjoyable holiday around their favorite barbecue, lake and beach.
Housing was the big ugly we told you it would be. May new home sales were even worse than we feared, though existing home sales fared a bit better. The latter fell from April, and although a surprised market had dialed itself up an increase based primarily on what might be termed a deluded sense of vague optimism, the drop wasn’t as bad we thought it could have been.
The annual rate of 300,000 for new home sales hit a new low in a series that goes back to 1963. Given the post-WWII construction boom, it seems a reasonable guess that the series hit a post-Depression low. Some say these lows must indicate bottoms, but that logic has been failing since the autumn of 2006.
The consensus estimate was for 400,000, which tells you how wide of the mark the actual result was; not only that, but March and April suffered big downward revisions. It’s no wonder that the homebuilder sentiment index in May took a sharp U-turn back into the basement. Despite the sharp decrease in new supply (months of supply may be up because of lower sales, but builders have sharply reduced construction), the average number of months a new home is for sale still stands at 14.2 months, not far from the all-time high of 14.5 months.
As homebuilder Lennar (LEN) observed in its latest earnings release, some of the national picture is being muddied by edge areas, where foreclosures still run high and abandoned developments sit idle. Fair enough, but those areas are also where the industry’s growth had been. Without them, homebuilding will continue to run at depressed levels: Lennar’s executives referred to conditions as “a rocky, stabilizing bottom with visibility obscured by more questions than (any) clear answers.”
Both Lennar and fellow homebuilder KB Homes (KBH) reported year-over-year declines in their quarterly operations, a comparison to a time that was also thought to mark a bottom. Management was happy to dwell on the long-run benefits of affordability ratios and falling mortgage rates, but when asked to talk about the current quarter, “not so much,” as Borat might say.
We agree with one point that Lennar and KB management both made, which is that new home construction will be aided by an improving sense of employment confidence. Despite the stubbornly high levels of weekly claims – ironically enough, boosted in part by continuing layoffs in residential construction – we do believe that employment is on a gradual recovery path.
Insofar as the homebuilders are concerned, however, neither the employment picture nor interest rates are going to have a positive impact on sales this year. We wouldn’t say that they’re whistling past the graveyard, because the big listed builders have managed to restructure themselves enough to wait out the drought, aided by huge tax refund cash from the federal government.
But the majority of the market (about 75%) these days is for homes $300,000 or less. It’s hopelessly naïve to pretend that a sizeable chunk of this market was unmoved by the tax credit, yet is now ready to jump in based on a twenty-five basis point drop in interest rates. For the median new-home sales price of $210,0000, $8000 up front is a far more powerful inducement than a $25 savings in monthly payments.
As for employment, anybody who wants a loan now needs three years of documented income. A return to the employment rolls won’t mean a mortgage this summer for any but those who had enough means not to need it anyway.
No doubt that the homebuilders are encouraged by stories of growing demand for mortgage paper coming out of banking, but there are significant problems in attempting to translate that into additional sales.
Start with the banks: they really don’t want to lend money to homebuyers. An immutable principle of banking seems to be the boom-and-bust cycle, when banks get caught up in some lending mania and finish by losing their shirts when the bubble bursts. This is invariably followed by a period of remorse, during which the industry treats its once-fair child like a leper. That’s where mortgage lending is today.
The banks are more than happy to originate home loans, of course, provided that somebody else will buy them. Except for the odd favored customer, they really don’t want to hold anything on their books. That’s why you still see ads and hear talk about “our commitment to lending” - it’s really a commitment to loan processing.
Another constraint is that the buying interest in mortgage paper is predicated upon the possibility of a slow-to-deflationary economic environment. Any sustained uptick in employment would mean an immediate uptick in rates as investors pulled back. Over time, continuing improvement in employment would certainly overwhelm the interest rate effect, but not this summer, and not this year.
A large portion of the existing home market is either underwater or at levels at which owners don’t want to sell. That’s keeping a big segment of potential buyers and sellers on the sidelines, and is especially damaging to the trade-up market. Did we mention that the GSE’s are putting back bad mortgages to banks, demanding financial verification, or that home ownership is still above the longterm average?
The homebuilders and their supporting brokerage analysts scrambled to put the best spin on results, just as some of the eternal optimists and market apologists are trying to ignore the truly ugly levels of mortgage purchase applications and instead blame the shortfalls on delays in processing foreclosures. Or was it that Edna was on vacation that week? This summer is clearly a dry season for homebuilding and so is the year. Don’t be fooled into mistaking the occasional bump in the path for a hill - those March and April revisions (a net loss of 108,000, or about 11.5% of the original total) tell the tale.
Turning to employment, we seem to be back to last year’s game of bogus weekly comparisons. The revisions are consistently higher every week of late, so the comparison of the preceding week’s upward revision with the current week’s toolow total leads to a steady beat of weekly changes that overstate declines and understate increases. We suspect that the administration is not in a hurry to call anyone’s attention to the problem.
That said, some special factors could be playing into the current high levels of claims and a likely weak June number for the jobs report next week. It’s been noted elsewhere that census worker payrolls contracted sharply in the first two weeks of June. That could be having the dual effect of keeping current claims high, as the workers roll off the government payroll, and putting a damper on total jobs for June.
The market has certainly baked that in, with consensus estimates centering around a loss of 100,000 for the month. It could be worse, but by Friday the market will probably be prepared to ignore a big red and ready to focus on private sector payrolls instead. Those are expected to increase by around 100,000, but we think that estimate at risk from a slowdown in manufacturing hiring, if the regional surveys are to be believed.
But if the improvement in the “current conditions” component of the University of Michigan consumer sentiment index is to be believed instead, then employment should be improving. However, it didn’t correlate very well last month with the jobs report (though that could always be revised upward). The short-squeeze traders pivoted off the very minor revision to the June reading (76 instead of an estimated 75.5 – well within the margin of error) to push the tape a bit higher on Friday. Look for a bigger reaction on Tuesday from the Conference Board’s consumer confidence number.
There certainly were enough negatives outside of housing to have taken the market down further last week. The FOMC (Federal Reserve Open Market Committee, the holy overseers of interest rate policy) effectively downgraded their view of the economy, moaning that “financial conditions have become less supportive of economic growth” and that “bank lending has continued to contract.” The recovery is still underway, to be sure, but the statement certainly supports our “stair-step” view of lots of time-outs along the way.
The official “final” estimate of first-quarter GDP (until it’s revised again) was lowered again, to 2.7% from an original estimate of 3.2%. It isn’t unreasonable to say “so what?” with three days to go in the second quarter, but there were two little details we bring to your attention, the first being that the price deflator has crept up from 0.9 in its original edition to 1.1 in its latest. Still too low, but closer to reality. The other is that real final sales are now half of what was originally reported, 0.8% versus 1.6% (blame higher inventories). Quarterly corporate profits, though, got a good revision higher.
May durable goods were a mixed bag, pulled down by transportation, but the private business investment category did recover nicely. The factory orders report will give a fuller picture on Friday.
Next week has enough to disrupt the usual move to push the tape higher into the end of the quarter and beginning of the new month. It’ll start with May personal income and spending on Monday, plus something called the Chicago Fed National Activity Index, a reading that the market hasn’t really gotten used to following.
Tuesday will bring the Case-Shiller price index for April, and if it mirrors the rise in the FHFA (federal mortgage-based) price index, might help the market along in its quest to finish the quarter higher. The Consumer Confidence number that day has bigger potential, though. The bold consensus estimate calls for the same reading as last month.
The action heats up after that, with Wednesday being the last day of the month and quarter. The ADP June payroll survey and the Chicago Purchasing Manager’s Index (PMI) report before the open, along with quarterly earnings from fast-money staple Monsanto (MON).
Besides being the first day of the month and reporting weekly claims, Thursday also sees June auto sales, the ISM manufacturing survey, April construction spending and pending home sales. The ISM really isn’t predictive, either of the economy or the stock market, but it’s closely watched anyway. The consensus is for a very mild pullback from last month, but if the regional surveys are to be believed, the reading will be lower than that. Auto sales might be the best read on where the economy is going, but will probably move the market the least.
With the ISM on Thursday and the June jobs report on Friday (followed by factory orders), the eve of long holiday weekend, the week could easily have a crazy finish. We wish we could tell you in which direction, but we don’t have access to the computer code.
Avalon Asset Management Company is a Registered Investment Adviser
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