Avalon Asset Management Company Lexington, Massachusetts Investment Management
Avalon Asset Management Company This Petty Place
"Tomorrow, and tomorrow, and tomorrow, creeps in this petty pace from day to day." - William Shakespeare, Macbeth
It’s London in Manhattan. For whatever reason, the jet stream has strayed further south than usual at this time of year, resulting in a June more reminiscent of our London days than anything people in the Northeast are accustomed to. In other words, cool, wet and gray. It’s no wonder the market hasn’t been able to stage an upside breakout, or that trading volume is low. Who can get any animal spirits going in the face of all this endless damp? Even worse, we hear that the stream is due to stay lost for another month. Time to start selling call options.
In keeping with the times, the markets flailed around with little energy last week, finishing the week more or less where it started. We passed the time by dumping some rain on the head of Fed chairman Ben Bernanke, recycling boring arguments about the dollar, inflation and valuation, and crashing Internet servers around the country with the news of the death of pop icon Michael Jackson (may he rest in peace).
Even with the rain, it was hard to believe the latest episode of NationsBank’s Ken Lewis (yeah, we know, they pasted Bank of America’s name onto the stationery, but trust us, it’s still NationsBank). After coveting Merrill Lynch for years, he had the company literally fall into his lap, cushioned with federal guarantees. Three months later, he went back to Washington with threats and demands for more money, and then departed with another $20 billion and a few admonitions (poor guy, does B of A have to expense those warnings, or can it amortize them?).
I know – if you’re a legal-minded sort, you might be wondering, “isn’t that called extortion?” But when journalists jumped in front of Lewis and said, ‘good golly Ken, Merrill was losing all that money in the fourth quarter (on paper), how come you didn’t tell anybody?’ - he had the crust to look up sorrowfully and say, “well you know, they made me do it.”
In the words of the immortal John McEnroe, you cannot be serious. Just ask some other bankers, starting with the long list of former bank CEOs that Lewis sweet-talked to the altar and then left in the ditch (“do not listen to all those lies, you are the only one I’ve met who can inherit my throne”). It’s a list that would make Casanova green with envy and Machiavelli ask for his Cliff notes.
Ken Lewis has been, hands down, the most ruthless executive in American banking in the last two decades. The notion of ‘poor Ken’ being forced to take Merrill with only another $20 billion in guarantees must have Fed chairman Ben Bernanke gnashing his teeth down to the roots and wishing he’d left Lewis taking a meeting at the bottom of the Potomac. Take a number, Ben, right behind John Thain. He was Merrill’s last chairman as a stand-alone company.
Mr. Lewis now has Countrywide Financial printing money for his bank, and is telling former Merrill Lynch execs who want to buy the company back – you know, the one that the Fed forced him to take six months ago, at gunpoint – that he has absolutely no interest in selling the company. We haven’t heard of a better comeback from death since Lazarus was seen to come strolling out of the tomb.
And now by mysterious coincidence, a posse of Southern and California Republican congressman have risen up and demanded to know if Bernanke – who is only the bank’s chief regulator and backer - had the temerity and supreme, free-market-destroying gall to rap Saint Kenneth on the knuckles and tell him to the start behaving. Who does Bernanke think he is, after all? Some kind of regulator or something? Doesn’t he know he’s just a customer-service agent?
The irony is that Bernanke was being grilled for saving Merrill, the right thing to do, rather than for letting Lehman go, which was catastrophic. We wrote last week that while the Fed and Treasury are anxious to have specific powers in place for systemic crises, we thought that the Fed already had enough power to save Bear Stearns, Lehman Brothers and Merrill Lynch - it all comes down to who is in charge. Yet looking at the stupid heat that Bernanke had to take for doing the right thing to save the system, one can understand why the feds want something more specific.
Do not think, dear readers, that we are mere Wall Street flacks. It wouldn’t have bothered us a whit to see most of the Street’s chief execs strung from lampposts up and down the sidewalks of Broad Street and Maiden Lane, pockets picked clean, for the magnitude of their sins. That goes for their boards, too. The presence of trolls does not condemn the bridge, however.
Throughout the financial crisis, Congress has repeatedly managed to look petty, parochial and vote-grubbing in its televised hearings. Grandstanding in place of logic, good faith or any ideas of public good is nothing new in politics – as Bismarck once said, the details of diplomacy and sausage-making are best kept out of view - but do we have to have this televised cheese? It will drive more people to the Internet; so surely the networks can see the danger. Our representatives might also behave themselves a tad better if they weren’t pandering to the cameras. But that’s probably just another item on the impossible dream list.
For the record, Lewis may be completely ruthless, but he has made it plain time and again that he is nobody’s fool. In the case of both Merrill and Countrywide, we felt (and still do) that the acquisitions would prove to be coups for his bank. We aren’t fans of his style, but he has been a deadly force in banking. We wouldn’t ever work for him, but in terms of the stock price, the bank’s shareholders will have little to complain of in the end. That doesn’t mean we buy the act.
There’s a little bit of complacency creeping into the stock market lately. We note that the post-war high for the unemployment rate is 10.8%, set back at the end of 1982. The market did put on a big rally at the end of that year, but this time Paul Volcker won’t be standing there ready to lower the ropes with an announcement of lower interest rates.
Yet traders are starting to shrug off eleven percent unemployment as inevitable, but not anything to really worry about. Yes, well, it isn’t necessarily bad news that rattles markets, but disappointment – and we’re starting to set up for it. The momentum for this week is widely accepted as positive on the Street: end-of-quarter markups, new month money, a holiday-shortened week. It’s another reason to be a little more cautious. The Street has a funny way of ending up on the other side of the obvious trade.
We wish our American readers a pleasant Independence Day weekend, and remind all that U.S. markets will be closed on Friday the 3rd and re-open the following Monday.
The news of the week was that there wasn’t any. Not anything that could stir the market, anyway. The maddeningly mixed nature of the current period continued, with every disappointment qualified by an offsetting gain, and neither of them producing anything really definitive.
The biggest beats of the week were personal income, on the upside, and weekly claims, on the downside. Personal income leapt by 1.4%, about a full percent higher than expected, and that sent futures up in the pre-open for about two minutes. The problem was that all of the increase came from a surge in government transfer payments, $162.6 billion to be exact, while private sector wages fell by more than $12 billion. In light of that, the spending increase of 0.3% didn’t look as good. It met the consensus, but it means the savings rate continues to grow, and we’ve all had a chance lately to read about the paradox of thrift.
Weekly claims defied consensus (but not MarketWeek estimates) by rising to 627,000 (more likely 631,000 after the weekly revision of 4,000-plus). That sent continuing claims and the four-week moving average back up again. We made the point again last week that claims are still under pressure from auto-related layoffs at plants and dealerships, while the end of the school year is throwing in some additional numbers.
Yet next month, claims could drop suddenly after those two bulges have worked their way through the pipeline. That doesn’t necessarily mean much improvement in the job market, but in the same way that inventory reductions eventually clear the shelves to the point that companies can’t draw down anymore, most sectors will have shed enough workers in a short enough amount of time that they will have to take a pause. In addition, automakers will start to resume production in bits and pieces.
Combined with the births-and-deaths model additions from the Labor Department, that could mean a big improvement in the July labor report (with most of it revised away in January, when it will have no impact). It would make for good headlines, even if jobs won’t have become a whit easier to find and more real people will be out of work than ever. It’d still be good for equities, though, and probably even business confidence. The unemployment rate will keep climbing, but we already know that, as traders like to say.
We also predicted that last week that the Fed would try to stay as unchanged as possible, and that rather easier prediction also came to pass. The committee was unchanged with a vengeance, leaving only tiny changes in the text as crumbs to worry over. The fantasy talk of imminent Fed tightening died down again, but it’ll be back again in the fall.
The Personal Consumption Expenditure (PCE, or spending) data contained in the GDP and personal spending reports put an additional damper on inflation fears. First-quarter total PCE was reported at 0.9%, while the core remained at a low 1.6% annual rate. May reported monthly increases of only 0.1% for both rates. Year-on-year core inflation was reported to be 1.8%, while thanks to lower energy prices, the headline total was essentially unchanged.
But wait, you may wonder, what about the durable goods report? Fair enough – new orders were alleged to have risen 1.8% in May, or 1.1% excluding transportation, and non-defense capital goods excluding transportation – business investment spending, for short – rose 4.8%, the sharpest gain in years. That, however, is because the level of activity is so low. Year-on-year comparisons don’t look so bright – excluding transportation, new orders are down 23.4%, while the capital goods indicator is down 24%.
If we wanted to be mean, we could point out that you have to go back to 1995 to find lower levels of new orders for May. If you want to be really mean and use real terms, we’re back to pre-1992 levels. Then there’s the per capita basis – well, never mind.
Still, a bounce has to start somewhere, and the uptick bodes well for next week’s factory orders data. That strength isn’t being echoed in retail sales reports, however, which continue to be unusually weak. It’s partly due to the rotten weather we’ve had in the Northeast, but the outlook for the next few days don’t look promising enough to reverse the trend. Shipments and inventories of durable goods continued to fall, which could drag on this quarter’s GDP while helping the next quarter, when they are rebuilt.
The new orders strength wasn’t echoed in housing either. Existing-home sales rose a modest 2.4%, below consensus estimates of about three percent, and are still several percent below year-ago levels. New-home sales were more disappointing, falling a few percent instead of rising, with downward revisions to previous months adding to the gloom. Pricing isn’t falling as much in new homes, which are now down only 3.6 percent from the previous year, compared to existing home prices that are down about seventeen percent over the same period. The Case-Shiller index will check in next Tuesday with its own price report.
Foreclosure sales slowed again and dropped to about one in three transactions, down from about one in two in early spring. A continuation of that trend would improve the mix and help the median price start to tick up, even if individual home prices were to continue to fall. In any case, mortgage-purchase activity remains anemic. We are sitting on the bottom and there is still no sign of the turn, so sayeth the CEOs of homebuilders Lennar (LEN) and KB Homes (KBH).
Consumer sentiment was the last data point. The Michigan semi-monthly survey inched up a notch, back up to the seventy level for the first time since last September. That didn’t turn out to be such a good indicator. Optimists touted the increase in current conditions, pessimists pointed to the flattening in future expectations. The Conference Board will report its sentiment index on Tuesday, and has shown sharp improvement of late from its record all-time lows. Should it flatten out, it might be deflating to the markets. Whatever improvement it may show, it isn’t showing up in those chain-store sales reports.
The holiday-shortened coming week is packed with data into three days, with no reports on Monday, and Friday a holiday. Besides the consumer confidence, home price and factory orders reports, we will get a load of survey data on output and employment.
The Chicago Purchasing Manager’s Index (PMI) reports on Tuesday, and if it follows the trend of the recent Chicago Fed survey, will show a decline. Yet the Philadelphia Fed survey from the same week showed a marked improvement in the rate of decline, and is thought to be a better indicator of the national ISM number that comes out on Wednesday. The latter has been creeping steadily higher. We have said that the monthly decline must eventually shift to a neutral comparison, or the magic fifty level. Although next week’s consensus is for a very marginal improvement to the 44 level, it could easily be higher.
At the same time as the ISM for June, we will get construction spending and pending home sales for May. That will make for quite a bit to digest. Earlier that morning comes the two job-market teasers, the Challenger and ADP reports, and motor vehicle sales start during the afternoon. All that data ought to break up some of the indecision in the markets: construction spending has been consistently underestimated for some months now, as have pending home sales. It’s plain that the Street sees little reason to stop handing itself positive “surprises.”
The week is punctuated with the jobs report for the month of June, so it’ll be time to buy stocks, right? It’s become a given that the stock market rises on the jobs report, first because it’s never as bad as it could have been, and second because we’re closing in on ten to eleven percent unemployment. You might mistakenly think that that would be bad news, but you aren’t thinking like a trader. It means we’re closer to the turn.
I’m not being cheeky. After the close on Friday, “Fast Money” traders on CNBC were making the first and last observations – buy the jobs report because the market always rallies on it, and we all know we’re going to eleven percent so the sooner we get there, the sooner things start to turn around.
That sums up a lot of Wall Street thinking in action. Until that night, the peak estimates I had heard tossed around for the unemployment rate were in the area of ten to ten-and-a-half percent. The Street loves to get ahead of bad news in order to defuse it, so eleven percent is now being uttered, just in case we get there. Eleven percent is no big deal, the recession is almost over, because that’s what the tape is telling you (those are quotes). I wonder what the tape was telling them last August.
We think that the divergence between the jobs number and the unemployment rate will continue for some time. The Labor Department’s births-and-deaths model added over 200,000 jobs last month, and we are skeptical that the number of jobs lost dropped so dramatically in the face of a weekly claims rate that was as elevated as the May rate. It isn’t that the Labor Department is trying to cook the numbers, but best-fit estimation models tend to work better during more “normal” times – just ask a black-box trader.
Perhaps by the first quarter of 2010, Labor will work up a revision that finds it overestimated jobs by a million or so, but the market rarely reacts to news about past data. In the meantime, it isn’t as if there is going to be any groundswell of pressure to report additional lost jobs. The market has dialed in a small ratchet back up next week, but as long as unemployment stays under ten percent for one more month and we don’t cycle back above 500,000 jobs lost, it won’t get too rattled.
It seems to us that the market has set itself up nicely for next week. Estimates are for little to no improvements, even in areas such as consumer confidence or factory orders, which have plainly risen. Things are almost too pat, and that is something to keep in mind.
StockWatcher will return in a later edition.
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