Avalon Asset Management Company Lexington, Massachusetts Investment Management
Avalon Asset Management Company Blowup
"Foul deeds will rise, though all the earth o'erwhelm them, to men's eyes." – William Shakespeare, Hamlet
Fans of the movie Blow-Up may recall that the plot – such as it was – turned around a disappearing body. It appeared in photos, but then it wasn’t there. Director Michelangelo Antonioni might likewise have put together the chart below of the S&P 500 for the last two years.
The equity was there, but now it’s gone. Another who-done-it, also accompanied by glamorous models (it’s pretty obvious what the number one criterion is for being a newsreader on CNBC and Bloomberg television), and a plot that has many baffled. Where did our money go? Did we ever really have it? For that matter, where has my home equity gone? Median home prices have now returned to 2004 levels (though Manhattan, Greenwich and some other locales have escaped).
In another dreadful week for equities (-4.2% on the Dow, -2.9% on the S&P, -3.8% on the Nasdaq), the indices fell to levels of down roughly fifteen percent year-to-date and close to the twenty percent drop from the peak that would officially constitute a bear market. Like we needed official confirmation, right? Yet there was a stalwart fellow on CNBC Friday insisting that this is not really a bear market, though he admitted that “technically” we might be “near one.” (If you’re wondering, the answer is yes, he’s a fund manager).
There are two or three important currents running right now on the Street. One is that so far as equities are concerned, traders have absolutely no buying conviction. Rallies are being sold within hours, if not minutes. Another is that there is virtually a universal consensus that we are headed for a bottom, hopefully within a few days, but that we’re not there yet. Technicians allow that the market is oversold, but see little hope against the larger downward pull. The market is practically desperate for a VIX-popping cathartic sell-off (the VIX is the chief volatility index and usually peaks during capitulations).
The other current of course, would be oil. Another week, another spectacular increase, another record close. Oil is simply slapping the equity markets silly, so badly that one observer was moved to claim that if equities go down for any reason, oil goes up by reflex anyway. By Friday there were predictions that we could hit $150 by the end of next week. It’s kind of reminiscent of the Dow’s abrupt charge to 14,000 a year ago next month.
How will this play out next week? On the one hand, Monday and Tuesday represent quarter-end and the first day of the month respectively. Usually that’s positive for equities, due to window-dressing and new money flows. On the other hand, nobody wants to buy stocks quite yet. It doesn’t help that next week is a short week (Friday, the 4th of July, being the American independence day holiday) and that the employment report is due on Thursday. With the latter not expected to be a source of good vibrations, it’s another reason not to get long. As one wag observed last week, nobody has been rewarded lately for buying early.
Yet another hurdle to cross on Thursday is the European Central Bank’s latest announcement on interest rate policy. As the former home of the German mark (and with evil memories of hyper-inflation), Germany is the philosophical heart of sound money policies. It is also the European Union’s largest economy. ECB Chair Jean-Claude Trichet, therefore, is obliged these days to be more German than the Germans in order to keep all hands on board. With EU inflation running well above target levels, Trichet is threatening to raise rates.
Well Jean-Claude, nobody wants a wage-price spiral, but you might want to ponder a few things. One is that if you raise rates, the Euro will go up, the dollar will go down, oil will go up some more and you’ll likely end up with more inflation, not less. We understand that you have to talk the talk, but will you really take the walk?
It may be, of course, that M. Trichet is perfectly aware of all of this. He may be hoping for a couple of other things to happen. One would be that it would pressure the Fed to raise rates as well, thereby supporting the dollar (stop being so foolishly soft, you silly Americans). Obliging the Fed to follow the ECB would result in unprecedented ecstasy in European government: they would probably canonize Trichet in France and rename the Euro in his honor.
The other possibility is that Trichet knows that the ECB can’t slow down emerging-market demand directly, so he’s willing to do it indirectly by allowing the European economy to go into the tank, thereby taking away a top customer from the emerging bloc. He may not be the only central banker willing to trade some more economic weakness in exchange for nipping the inflation spiral in the bud. If that’s the case, then equities are going to be in for a rough time, because twenty-five basis points isn’t going to do the job.
Did you see the new pricing pact between Baosteel (China’s biggest steel producer) and Rio Tinto (Brazil’s biggest iron ore producer)? It raised the contract price for iron ore by eighty-five percent, retroactive to April 1st. We’re all going to feel the effects of that price increase, including China, but it isn’t western demand that’s driving steel production, not directly.
No doubt you saw some of the other good news. The stock price for General Motors (GM) dropped to its lowest level (intra-day) in fifty-three years. Now there’s a cyclical stock. Come Monday, if stock prices are unchanged or down, it’ll make it the worst June for the stock market since – ready? - 1930. Japanese business surveys show a belief that they’re in a recession. Tech leaders Research in Motion (RIMM) and Oracle (ORCL) issued disappointing second quarter outlooks on Wednesday, a development that took the starch right out of tech stocks, $20 a share out of RIMM and a big chunk out of market sentiment.
The investment banks passed the week with a circle of downgrades of each other in a display of cattiness that had the major news outlets snickering. Speaking of which, Morgan Stanley (MS) was put on credit watch, and Merrill Lynch (ML) is said to have another $4-$5 billion in write-downs coming. Barclay’s (BCS) raised about $9 billion in new capital, but Citigroup (C) promptly came out and said that they might need double the amount. European bank Fortis said that they would skip the dividend in favor of raising another $12.5 billion. As baseball immortal Casey Stengel once said, “can’t anybody here play this game?”
And speaking of blow-ups, is what may be the unkindest cut of all, it was reported that the demand for plastic surgery is suffering a dramatic drop-off. Specifically, boob jobs and botox. Yes, that’s right, boob jobs and botox are down, while oil and gas are up. What’s the country coming to? Is there any good news at all?
There was, sort of. The personal income and spending report came out on Friday (see The Economic Beat below) and the market didn’t react. Admittedly, the numbers were goosed by the rebate checks, but nonetheless the real spending numbers were better than expected, as were the personal consumption expenditure data (the Fed’s inflation gauge). As far as second quarter GDP goes, this will be a plus, even if a lot of it is going to the Mideast.
This is the first time in years that the market didn’t get all perky at a whiff of good news. That’s a sign that we’ve entered the bottom phase. Backing it up, more than ten percent of Nasdaq stocks made new lows on Thursday. The Journal reported that that’s happened fourteen times in the last ten years, and each time the market bottom has hit within thirty days, within a week on twelve of those occasions.
Another favorable technical development is that the Boston Celtics overwhelmed the Los Angeles Lakers in the latest installment of their NBA championship rivalry. The last time the Lakers prevailed against the Celtics in the finals was 1987, and we all know what happened that year.
Don’t get too excited, though, because the actual bottom could easily be another five or ten percent below where we are now, and once there we may be in for an extended stay with no free upgrades. Despite those fourteen times, there’s only been two bear markets in the last ten years, in 2001-2002 and 1998. In fact, all of the last three bear markets – 1990, 1998 and 2001-02 – saw prices collapse in July, yet none of them bottomed out for good until the fall. It does look as if the beginning of the end is at hand, but only the beginning.
The economic week got off to a gloomy start on Tuesday with the fifth-worst confidence reading ever by the Conference Board. The expectations component set a record low. Consumers are unhappy, but the weekly chain-store reports were the best that they’ve been all year. Obviously the rebate checks are showing up in the data, but one explanation could be that consumers are only buying what they need, rather than what they want. They’re certainly not buying cars or houses or much else in the way of durable goods.
The durable goods report itself was released before Wednesday’s open. They were unchanged, as expected, although excluding transportation they were down. Year-over-year, they’re down (-1.5)% . The business investment category, non-defense capital goods, was up 0.4%, but that’s not much of a recovery from April’s drop. Considering the tenor of the assorted surveys and reports from the week before, traders were relieved that it wasn’t any worse. Anemic is the new good.
New home sales came in light, at levels that are probably at a post-war low on a per capita basis. Year-over-year, they’re down a breathtaking 40%. Despite the slowdown in starts, inventories are still rising, up to 10.9 months.
The Case-Shiller home-price report showed an annual drop of about 15% through April, and prices have now returned to 2004-2005 levels. However, some metropolitan areas showed a bit of improvement on a monthly basis. Despite the improvement, we don’t view the current period as the bottom, but as a pause, and a hopeful sign that the steepest part of the decline is ending.
It is the buying season, after all, and while unemployment is rising, it isn’t rising to levels that are historically exceptional. Although income is stagnant overall, professionals outside of financial services aren’t doing badly and a return to prices of a few years ago – or even supply of a few years ago – has to be tempting some people back into the market.
Although lending is constrained, anybody who bought prior to 2003 or so and didn’t try to cash out the equity is going to have enough equity in their home to be able to obtain another loan. That is the good news.
The drawback is that unemployment will probably keep rising, albeit slowly, for the rest of the year, and although banks are still lending, credit conditions are undeniably tight. Mortgage applications fell again last week to very low levels. As the peak selling season fades, we are likely to see a last leg down for housing conditions through the winter and into next year. It shouldn’t be as dramatic, but it isn’t going to be a source of stimulus until next spring at the earliest.
Existing home sales were up 2%, about on target and better than expected. No, I didn’t say the wrong thing. They did meet the consensus estimate – barely - but in the climate of the day that was better than expected. It didn’t help much at the time, because the report was overshadowed by other data. Weekly jobless claims stayed at an elevated level and continuing claims reversed direction again to a new four-and-a-half year high. Worst of all, oil prices, led by the confusion over the FOMC statement, rebounded to new highs despite an unexpected build in supplies.
Ah yes, the FOMC statement. The committee met last week and issued a firm “no change” statement (as usual, Dallas president Richard Fisher dissented and voted again for a rate increase. Rumors that he would appear on CNBC with a leather whip and hob-nailed boots were apparently unfounded). The markets seem to like the news that afternoon, but the next day it would appear that they were less pleased. Perhaps they had had time to reflect on the Fed’s shift to worrying about inflation. After all, it was right about when the Fed began to officially worry about housing that things really started to get ugly.
Some would have liked a rate increase, or at least more of an implied threat, on the premise that it would have strengthened the dollar and weakened the oil trade. Given that oil is the last working trade left standing, that’s not so certain. Things usually have to get sublimely ridiculous before the money river finally gets the impulse to look elsewhere.
As mentioned above, the personal income and spending report had some good news. It wasn’t quite as good as some tried to make it out to be, but it wasn’t at all bad. Income excluding rebate checks was on target, and real spending increased. The core PCE price component was up only 0.1%, although the total was up 0.4%, a worrisome annual rate. Commentators were right to worry about the latter and wonder how long the spending boost would last, but the difference this time was that the stock market worried about it too. That’s a real change.
The non-event of the week had to be the news that the latest revision of GDP for the first quarter came in right on target at 1.0%. How little impact that made was apparent in the following day’s Michigan consumer sentiment survey, which showed the lowest readings ever outside of the 1980-82 recession. Like any other snapshot, GDP is an imperfect measure of the whole economy, and besides not taking a weakening job market into account, it doesn’t take into account either the asset hemorrhaging that is occurring with the consumer as the value of housing and retirement plans – the two biggest assets for most people – fall sharply. The confidence numbers show that pain.
Next week is a short one and likely a sharp one. We get the two ISM national surveys, with manufacturing (expected down) reporting on Tuesday and services (expected up) on Thursday. Monday will lead off with the Chicago PMI report, which is expected to weaken somewhat given the tone of recent surveys.
Construction spending is reported on Tuesday (probably down) and factory orders on Wednesday. The latter is expected to increase, although price increases in petroleum-related products have been boosting the number. Thursday is the obvious day of the week, with the potential ECB move, the employment report, weekly claims, ISM services, early closes in the bond and commodities markets, and probably a very large group of equity traders heading out and not returning in the afternoon. We could all use a breather.
StockWatcher is going to present two ideas over the next couple of weeks that represent a relatively safer way to start taking the other side of the oil bubble. There’s going to be one important caveat, though: we don’t think you should buy them quite yet, just put them on the radar screen.
The first one is refiner Valero (VLO). Valero has been getting quite a bit of attention in the financial press lately, and we can understand why. At Friday’s close of $40.10, the stock has been sawn neatly in half from its high of last summer. The main thesis of late, which you may well have seen, is that once oil breaks, refinery margins will improve and so will the stock prices of the group.
Valero certainly doesn’t look expensive. It’s trading at about book value, six times trailing earnings, a little higher than eight times cash flow. The company raised its dividend, is buying back stock, selling assets, in other words doing the usual things to entice shareholders.
We brought up the refiners ourselves as a possible point of interest last fall, contingent then as now upon the price of oil losing momentum. It didn’t, and we stayed away from the stock and the group. Now oil is a lot higher, and the group is a lot cheaper.
Time to pull the trigger, then? Not quite, but do put it on your radar. The reason we counsel caution starts with our conviction that the stock market has one more hard landing in store, but that many bargains are starting to pop up. In addition, we think it more likely than not that oil has one last ridiculous thrust upwards left in it, partly because that’s the way these things usually happen, partly because it’s the last long trade that’s still working, and partly because more money will flow to oil if the weakened stock market keeps fading.
If those aren’t enough hurdles for you, consider one more. Suppose you are a hedge fund manager that wants to start building up some positions now in beaten-down stocks, but that you are justifiably worried that oil could have one last spike left in it. What do you do?
Oil stocks aren’t keeping up anymore, and selling oil futures can be a headache. So rather than put up any money, you can short refiners and use the proceeds to buy those bargain stocks. If oil keeps going up, refiners will go down. That’s another source of selling pressure.
If Valero hits $35, we’ll look to start a position. If it gets to $30, we’ll bring the truck. That may seem a bit too greedy or faint-hearted, but $30 isn’t as far off as it looks. Valero last traded at $30 in the spring of 2005, and quite a few cyclical sectors have gone back to those levels. Unless oil definitively breaks, keeping some extra cash in your pocket into the autumn won't hurt.
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