Avalon Asset Management Company
Avalon Asset Management Company
Should I stay or should I go? - the Clash
by M. Kevin Flynn, CFASentiment in the markets stalled noticeably last week. The daily action in equities was frustrating to many, as it mainly consisted of reversing direction. Every time a move seemed like a sure thing by getting to the triple-digit level in the Dow, it turned right around and headed back again. If the market was up in the morning it was down in the afternoon. The major indices all finished the week higher by tiny amounts, but Friday’s wild afternoon ride and the failure of the market to make one of its customary post-Fed charges plainly showed that some of the smugness has been taken out of the market (and some of its commentators, thankfully). Even the combination of a month-end, quarter-end Friday failed to get traders to step up to the plate. The anticipation of Merger Monday that had been such a Friday staple was replaced by a more fearful anticipation of impending hedge fund results.
Well, a little nervousness could be a good thing. It could set the stage for a quarterly earnings rally, for example. Nothing gets the party going on the Street better than finding out that the police aren’t coming after all. Although most are expecting earnings to improve by 6-8% for the quarter, Thomson reports that forecasts have been carefully tailored to a very beatable 4.1%. Right now, the fear level is high about a potential spiral of more securities being marked down, causing more margin calls, causing more withdrawals, so more securities get dumped and so on. The financial press this weekend was filled with worry about subprime mortgages, buyout financing, hedge fund results and what it all might mean for the credit markets. In addition, short interest keeps rising. But if hedge fund results turn out to be at least tolerable, if not inspiring, and some deals get done, we may see a potent rally as fears ease and earnings “beat” the comically low bar that the Street has set.
The markets are on edge though, make no mistake. An untoward event or two could set off some real fireworks. The Russell quarterly investment manager outlook had 17% saying US equities were overvalued, which is the highest level it’s been at in its brief 3-year history. The highly anticipated Blackstone (BX) IPO wasn’t aided by a weekend thrashing in last week’s Barron’s and sagged from the beginning of the week, only a day after its introduction. It stayed below its offering price throughout the week, a development that alarmed many traders about the market’s short-term direction. And as if food prices aren’t rising fast enough, drought is spreading everywhere. Four southern states had their driest spring in 113 years of record-keeping. Florida, Georgia and California have disaster areas that could become statewide.
Yes, there’s plenty to worry about. Britain is under maximum terror alert. Oil is up over $70 a barrel. Bank of America (BAC) reported that corporate tax receipts were down significantly in the second quarter, suggesting lower corporate earnings (it should be kept in mind, though, that those overseas earnings that the Street has come to love so much usually escape Uncle Sam’s taxman). To top it all off, there was a big spread in last weekend’s Wall St. Journal on a ninth-grade fund manager whose heroes are Maria Bartiromo and Jim Cramer. If that kind of a story isn’t a sign of a market top, I don’t know what is. Still, this market has had quite a knack for shaking off bad news and finding a way to confound the obvious prognosis. July should be interesting. The markets will take a breather by closing early (1 P.M. Eastern time) on Tuesday for the Independence Day holiday and reopening on Thursday. We wish our readers a pleasant holiday.
The Economic Beat
The last week of the second quarter stayed as mixed as its predecessors. It’s probably just as well, because by now the market has become so accustomed to mixed data that anything else might cause traders to run for the hills. In the current environment, a week of strong economic data would raise the inflation bogeyman, while a run of weak data would invite recession fears.
The news from the housing sector was as dreary as ever. The supply of existing homes for sales kept going up, unusually for the month of May, and hit a 15-year high. Year-over-year, existing home sales were off more than 10% and new home sales were down nearly 16%. In tune with the news, homebuilders Lennar (LEN) and KB Homes (KBH) reported steeper-than-expected losses, gave up on full-year guidance and said no bottom was visible. Not too cheery. Bulls have been trying to make the case that the ever-increasing supply overhang will lead to price declines large enough to put the market back into balance, but so far that all-is-for-the-best theory has been losing money. Having been burned several times by the Street’s announcement that the sector has bottomed, investors are staying away from it. The good news is that this is a necessary step on the way to a real bottom. The bad news is that it still doesn’t tell you where the bottom is.
On the manufacturing side, durable goods orders declined and were disappointingly weak. This news was accompanied by the noise of hundreds of chairs banging and crashing, as market mavens leapt up out of their seats to insist that in no way should one month of declines be interpreted to contradict the much longer two-month trend of improvement. Okay fellas, but the case is yet to be proven that the recent pickup in manufacturing is more than restocking. The Chicago PMI was a bright spot in that direction, though. While it was down from the previous month and is a small sample, it nonetheless checked in at a healthy 60.2.
Friday brought news that personal income and spending side were both weaker than expected. Although the “core” inflation component of the Personal Consumption Expenditure measurement was contained, the “non-core” component was up, as if anyone needed any more evidence about food and energy costs. Also worrisome was the news that real income declined for the second month in a row, spending numbers were propped up by higher gasoline prices, and the negative personal savings rate continued to deteriorate. Perhaps reflecting these trends and not just the price of gasoline, the latest consumer confidence numbers released during the week were in decline.
The president of trucking company Yellow Roadway (YRCW) offered up his assessment during the week that the economy is “fragile.” Trucking companies are usually good leading indicators of the economic direction, so he is well placed to know. It looks that way from here too. While there certainly doesn’t appear to be danger of a collapse anytime soon, we may first get a collapse in some of the complacent outlook about the economy.
Since last fall, the preferred market outlook is that the declines in housing and autos aren’t leading indicators, but secular corrections that can largely be overlooked. For the last two quarters, traders have focussed on increases in per share earnings that have been goosed by lower share counts, a weak dollar and strength in overseas operations, while ignoring the fact that domestic net income has plateaued. Of late, the comfortable version of common wisdom is that while many parts of the economy may slow, including consumer spending, business spending will inevitably pick us all up in the second half. The reason for this is essentially that since business spending slowed, it’ll have to pick up again. Why it has to pick up again isn’t exactly clear, but the white knight of Golden Global Growth is often invoked.
That’s one way of looking at things. But it could also be that we are in the midst of a long, slow turnaround in a longer trend that was fueled by an abundance of cheap money and credit. The collapse of the bubble economy in the beginning of the decade led to interest rates being taken down to historic lows in an effort to repair the damage. The early beneficiary of this extraordinarily cheap supply of money was the housing sector. As prices recovered, continued cheap credit led to a tsunami of money pouring into the sector and prices rocketed. As we all know, it got overdone and now mortgage investors and regulators are shocked – shocked! – to find that there was gambling going on in the joint.
In brief, it’s quite possible that the boomlet of recent years was fueled primarily by easy money, and to a lesser extent by the post-crash bounce. That same easy credit helped fuel a liquidity surge that has lifted all asset prices, perhaps to unrealistic levels (a top private equity executive was quoted this week as saying that buyout speculation has stock prices 20% above where they would be otherwise). In this scenario, the Bush tax cuts were mostly redirecting the flow of funds rather than instigating it. The luxury market is flourishing, profits hit record levels and executive compensation is astronomical, but the continued outsourcing of production may have left us with a base that was more tethered to the availability of cheap and easy credit that we realize. It shouldn’t come as a shock that we may simply have followed the path of least resistance.
Now that tide is slowly receding, and housing may once again be the leading indicator. Employment levels have remained strong, but employment is a lagging indicator and recent growth has been concentrated in service jobs at the bottom of the ladder. Asset inflation isn’t going to end all at once, but global rate interest rates are rising. At the end of 2002, nobody was predicting the ensuing recovery, and here in 2007, we may be looking at a coming turnaround of a different sort. The key to the next eighteen months will probably lie in credit conditions. Some of the shakier deals have been pulled or redone recently and sentiment has become more pessimistic, but the real test is coming in the heavy July and second-half calendar of buy-out financing. More trouble for the credit markets would mean bigger trouble ahead for equities.
This week’s lost angel in need of a little TLC is Freightcar America Inc. (RAIL). RAIL has a lot in common with another recent pick of ours, Komag (KOMG), who agreed last week to be taken over by Western Digital (WDC). At Friday’s closing price of $47.84, RAIL’s stock price has fallen over 20% from its high last September and is hovering near its 52-week low of $44.38. The company, which as you might guess makes railcars, lowered its guidance last week for the current quarter and is in the midst of a cyclical slowdown after a couple of boom years. If the market or the economy runs into more difficulty, transportation stocks will not be the favored sector.
And yet. The company also announced a nice new order for 1900 aluminum boxcars last week. The rail industry itself is moving away from steel cars to aluminum, which are much lighter and hence more fuel-efficient. RAIL happens to specialize in aluminum cars. They practically own the market for coal-carrying cars (the company estimates its market share at over 80%) and though the business may be lumpy, we don’t think coal production is going to be at risk in this country until and unless somebody manages to finally come up with that elusive cold-fusion process. The balance sheet is in wonderful shape, with no debt and a bit more than $15 a share in cash. It trades at about five times trailing cash flow and earnings, and even though that multiple is going to come up as earnings cycle down from the peak, it’s cheap enough to have attracted the recent interest of a couple of hedge funds. If Warren Buffet is right about the rails, this one looks a keeper – though at these prices, it may also appear to some like a target. Did we mention it’s at less than three times EBITDA?
The end of last week saw much ado about Apple (AAPL) and Research in Motion (RIMM). In the case of the iPhone, it became one of those media navelgazers where the chatter about the hype got more space than the product did. We’ll repeat our belief that the iPhone will be a big success and give our readers a break from any more on the subject.
With Research in Motion, though, where hype has been a way of life, it may have reached its zenith last week. The company did have a good quarter, though it wasn’t $7 billion of additional market cap good. But the market has been pretty starved lately for a growth company that doesn’t lower guidance – almost anybody can beat estimates these days – and RIMM is one of the only ones around the last few months that hasn’t disappointed. Yes, they beat revenue estimates – by 3%. That doesn’t equate to the 21% increase in the stock price. If RIMM can sell double the amount of Blackberries in the next five years that it’s sold in the last five, and triple the average selling price in the process, then I reckon its stock is fairly valued.
But I don’t think that’s going to happen. While the Nokias (NOK) and Motorolas (MOT) were busy with the much larger consumer market, RIMM pretty much had the much smaller corporate market to itself. The target of the consumer market is a younger customer that cares about coolness and “form factor” and prefers texting to email. The much smaller corporate market is an older market where email is a way of life. RIMM got its software first into the IT department, but it’s not like the software has a secret process that can’t be replicated. It’s just an email program.
The newer Blackberries are nice enough, but they’re not breakthrough phones. The biggest appeal of the newer models is that they’re not the bricks that the old models were. They look great to people who’ve been using them for years, like Wall Street analysts, but a new Blackberry model has never generated the buzz of a Razr or iPhone. The main user is still the corporate email department, and the main barrier to entry is inertia and the lack of competition.
RIMM just proudly announced that it's shipped its twenty millionth Blackberry. Apple plans to sell ten million iPhones by the end of next year alone. Motorola shipped 45 million handsets last quarter. Yet RIMM now has nearly the same market cap ($37 billion) as Motorola ($40 billion). Forget the endless promotion coming from the company and the brokerages, especially the Canadian ones. Just do the math.
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