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“Annual income twenty pounds, annual expenditure nineteen nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.” – Charles Dickens, David Copperfield
There may yet be more bears than bulls this week, which is not a bad thing. But the pendulum shift in the attitude towards financials, set off by Citigroup (C) CEO Vikram Pandit’s prophetic internal memo that the bank was profitable through the first two months of the year and on track for its best (pre-provision) profitability since the third quarter of 2007, started a riptide in stock prices. Not to be guilty by omission, CEOs Jamie Dimon of JP Morgan (JPM) and Ken Lewis of Bank of America (BAC) also envisioned that their banks would be profitable for the year and were running in the black through the first two months.
This bit of three-part harmony was the right stuff to finish off a nearly exhausted wave of momentum short-selling in the banks, one that had been barreling along on an obsession with potential write-downs and its status as the last momentum trade still standing.
Just as oil’s similar status last spring propelled it to absurdly overbought levels – accompanied, as usual, by the usual concoction of ju-ju theory whipped up to justify the unjustifiable – so the banks were taken down to absurdly oversold levels, accompanied by the end-of-all-days delirium chant that accompanies every recession.
The magic spell of doom was further rent by a parallel three-part counter to short-selling, bad loans and write-downs. Congressman Barney Frank announced his expectation that the uptick rule would be soon restored - expect the loudest screams that it won’t matter from those most inconvenienced by it - Treasury Secretary Geithner undermined the bad loan problem with plans for a public-private partnership to offload them, and Congress completed the circle with the onset of hearings about a relaxation of mark-to-market accounting. That put the shorts on the run, and for a couple of days the phrase “zombie bank” lost its status as the last word in hip financial slang.
Can it, will it last? That was the topic du jour on Friday, and the healthy skepticism that greeted the rally as just another bear-market rebound gives it a chance to go on. The outlook depends on your time horizon: a couple of weeks, then the odds are pretty good that you can trade into the financials rally and still make money. A few years, the odds are even better. If your outlook is a month or three, though, things are much fuzzier.
The worst of the write-downs should be behind us, but they are not all behind us. There will surely be some more bank failures, and though none of the big five will be allowed to disappear, there is still a chance that something will blow up and rattle everybody.
If the uptick rule, bad loan problem and mark-to-market easing were all to happen within the next month or so, there is the possibility that the market could get ahead of itself on the recovery in financials, leaving it vulnerable to disappointment. The herd might then panic all over again, fleeing the specter of nightmare outcomes (e.g., nationalization).
If the government were stupid or frightened enough to nationalize any of the big five, the equity in all of the survivors would immediately crash. It’s also conceivable that one of the European states could yet commit a similar blunder, which would have the same effect of weakening the group. That would quickly shuffle the doomsday chorus back to center stage.
From the point of view of yield spreads, i.e. basic profit margins for the banks, it is a great time to be in the banking business. However, the outlook on how much capital will be available to go to work and earn them is still uncertain for many: it isn’t all over yet.
We did a large eye-roll over the news that the Basel II conference is now underway to raise capital levels for the world’s banks, in order to really, firmly nail that barn door shut after the horses have left. One can raise the capital requirements to 100%, but if banks get caught up in another gold-rush fever to lend money before their competitors can, it won’t matter. What’s more, raising the capital levels now to protect the banks from making the kind of loans they already made, and won’t have the nerve to make for at least another five years, is going to do nothing but slow them on the road to regaining profitability.
The conundrum of banking stability isn’t capital levels, it’s the herd mentality and the nature of share-based capitalism. We have never seen the cycle disappear. At the height of every economic expansion, the most profitable lending business becomes a momentum bubble. The banks will knock each other over in an effort to book the lavish profits that are just begging for the taking. If they don’t, the share price lags, shareholder pressure grows and maybe a big “activist” investor comes along and puts a gun to their heads. The stock symbol appears on takeover lists, the financial press concludes that the bank can no longer compete, and managerial jobs are on the line. Thus the kool-aid is mixed.
The continued raising of capital levels at this juncture won’t accomplish anything but to impede the ability of the financial system and the economy to recover. It’s a backward-looking move. What’s more, it doesn’t do anything to stop rules from being vanquished at the most critical times, as happened with Paulson and the investment bank leverage ratios five years ago. The banks need to have a dispassionate regulatory framework that is able to take the punch bowl away as the party gets out of control, as is often said about the Fed’s mission.
So is the solution to give the Feds more power? Not necessarily, because if the times produce a chairman overly opposed to regulation (one name comes to mind), or a committee that is overly fond of regulation (think of the depression era), then we will still suffer. The fault lies not in our stars, said the poet, but in ourselves, in our own willingness to believe in bubbles, in our own tendency to believe that if some economic fix works in one specific time and place (like tax cuts or tax hikes, regulation or deregulation, rigid accounting or flexible accounting), it must of necessity work every time for every problem, and we invariably load up on it until we are all sick from it.
One cannot overturn human nature. It would be nice, though, if we could take advantage of the present crisis to outfit the system with more flexible buffers that tighten or loosen as new lending growth reaches highs or lows relative to levels of economic activity. That is the theory behind the Fed’s interest rate policy committee; perhaps we should be looking for ways to extend the process to protect ourselves from our own excesses.
One excess in current vogue is the exploding number of doomsday prophets, sociologists, and statisticians. This is a feature of every recession at its peak. When we heard one newly popular “expert” on public radio the other day tell us that in effect, we all need to get back to the land and start living like sensible hobbits again, it recalled to us similar lamentations from earlier hard times. The hard sermon always accompanies the hangover, it seems.
It may be of small comfort, but allow us to point out to the prophets and sociologists that as bad as the current situation is, and it is the worst financial crisis since the nineteen-thirties, for overall misery we still haven’t touched the seventies, nor are we likely to. Our apologies to anyone born in that era, for I am sure that we are fortunate that it produced you, but for adults it was a miserable decade whose nadir in the mid-seventies is still unrivaled for angst and gloom.
Consider that during 1973-1975, the stock market fell fifty percent and unemployment reached nine percent. We may exceed those levels somewhat now, but there was so much more then. The Arab oil embargo produced mile-long queues for gasoline around the country. States were forced to adopt systems of gasoline rationing, such as odd-numbered license plates one day and even-numbered the next. Gas station attendants were known to arm themselves, and many stations stopped selling to the public entirely, serving only known customers.
There was no wintertime protection for utility shutoffs: people froze to death while huddled around their kitchen ovens. New York City was a gritty, crumbling place, the New York of the films Taxi Driver and Mean Streets, beset by strikes (you would not believe the garbage strike), soaring unemployment, a suddenly vanishing manufacturing base and exploding crime (nobody went into Central Park after dark). It literally came within days of defaulting on its bonds and plunging into bankruptcy.
Can anyone from that time forget the sight of the fall of Saigon and the desperate locals throwing themselves at the last U.S. helicopter to leave? Or Watergate, the disgrace and resignation of our President, Vice President, Attorney General and more? What about Kent State, the fall of Iran and the brazen kidnapping of our hostages, the years of double-digit inflation (mortgage rates at nineteen percent), the hopelessly ineffectual “whip inflation now” campaign of Gerald Ford or the equally useless “malaise” speech of Jimmy Carter? Not to mention polyester leisure suits, those awful mile-wide ties, the worst haircuts anyone has ever seen since the dawn of time and the ascendance of disco. Yuk!
We don’t mean to slight the significance of the suffering of the newly unemployed, nor of the lives wrecked by foreclosures or Madoffs and Stanfords. We only point out that doomsday scenarios and impresarios were far more prevalent then than now, that far more of us were anguished over the world that our children might come into, that global angst was so widespread that it was a staple of stage, screen and the written word. I could fill pages and pages with a list of the daunting political and economic turmoil and disaster around the globe, and yet in spite of it all, in the end we survived and prospered. We will survive this situation too, and in all likelihood with much less misery.
Let's not forget the statisticians. There are some statistical “studies” floating around of late – as they always do at these times – purporting to prove that if nothing else, the old computing adage “garbage in, garbage out” still holds. One theory is that the price-earnings multiple on the S&P has not yet fallen enough. An unnamed strategist (Jason Todd of Morgan Stanley (MS)) concluded that during the three last worst recessions, the price-earnings multiple on the S&P had dropped into the single digits. Ergo, the current multiple on the index – currently at 14.5 times - must still not have fallen enough, and Mr. Todd projected that something about 560 would do it.
Using Mr. Todd’s methodology, we concluded that several hundred thousand French troops, possibly a million, had been killed or taken prisoner in 1989. We wondered how the news services failed to pick up the event, or ourselves for that matter, because we visited the country that year. Yet the German Army was present in large numbers on French soil in that year. The last three times that event had transpired, in 1870, 1914-1918 and 1939-1944, the outcome had been as we just described. After careful study, we deduced that a key element might have been left out of the trend analysis: the two countries were not at war in 1989. It’s remarkable how a seemingly unrelated variable can distort things.
The last three times that the S&P fell to single digit multiples were in the 1980-1982, 1973-1975 and 1947 recessions. Each recession was accompanied by soaring inflation at double-digit levels. That kind of thing tends to take the gloss off equities, especially when guaranteed double-digit short-term returns are available as an alternative in the fixed income markets. Contrast those times to today, when according to the Bureau of Labor, the latest measure of the current 12-month rate of core inflation is 1.7%. Mr. Todd may wish to have another go with his model.
The other “studies show” analysis that irks us is the one about how stocks that fall below ten dollars rarely recover. Now, if our equity markets were characterized by frequent fifty-percent corrections, such a study might be revealing. As it happens, though, there have been only three such events in the last seventy years. In fact, if you scan a historical chart of the equity markets, you will note that they follow a generally upward slope. I don’t need a statistical study to infer that if a stock price manages to go the wrong way and fall below ten dollars during a period of generally rising markets, there is probably something wrong with the company.
Perhaps these quants – and I was a bit of one myself, once upon a time – could draw some better conclusions by studying what typically happens when we have a market correction of over fifty percent, occurring during a period of very low inflation and substantial central bank easing. If you could add the catalytic collapse of a major investment bank, or a big commercial bank, that’d be a model worth looking at. But the only example of such an event is the one we’re living in.
Our counsel is to gather up such studies this Tuesday, fold them neatly, and take them to a good Irish pub where they will serve as excellent mats to place your pints on. Feel free to leave them behind at the end of your evening, for the bartenders know exactly the right place to put them. We wish a Happy St. Patrick’s Day to all.
Many a maven has been telling the media lately that a couple of days of good news were required to turn around market sentiment. We thought a few days of no news might help do the trick, and that turned out to be the case last week. As expected, government action and retail sales were the main events, and both had a positive bias.
The government did not actually say all that much, which helps the market. That isn’t to be snide, but to remind that the absence of detail gives freer rein to market participants’ best hopes. The actual event never satisfies everyone.
A perfect example of this was last week’s beginning of congressional hearings on mark-to-market accounting. For now, the working theory is that a certain amount of relaxation is in store, and that should benefit the banks, the critical organ. Whatever is actually done will inevitably come in for criticism, but for now the doctors are smiling at us and saying that they are going to try something that should make us feel better, and so we do.
Retail sales, the other pillar of last week’s recovery, came in much better than expected. Most surprising of all to us was the upward revision to January sales, from plus 1 percent to plus 1.8 percent: our guess was that the revision would be in the other direction.
The adjustments (for “seasonal variations and holiday and trading-day differences”) are crucial, because the raw data is all down sharply (it is the month after Christmas, after all) but we would be remiss not to observe that unadjusted February sales for department stores showed a nice gain. Shoppers may have been lured by sales, but the important part is that they came.
The February retail total was off 0.1% overall, where a loss of about a half of one percent had been looked for. Besides the strength in department stores, clothing and electronics also showed good increases. An interesting point was that gasoline sales rose 3.4%, although prices rose by over eight percent, indicating continued weakness in demand. Excluding motor vehicle sales – which are nearly frozen – and gasoline, sales rose 0.5% overall, a welcome bit of news to the markets.
There wasn’t much else of gripping interest. Inventory data was mixed, with indications of some stabilization against a backdrop of a continued decline in the inventory-to-sales ratio. Weekly chain sales reports are still down year-over-year, but the week-to-week numbers have been steady for some time now. Jobless claims were dismal again, at 650,000 with the usual upward revision to the previous week. Continuing claims hit a record 5.3 million, and that is going to be a boat anchor on any recovery.
Mortgage rates dropped significantly during the week, by eighteen basis points according to the Mortgage Bankers’ Association’s weekly survey. That didn’t do much to spur purchases, which remain mired at very low levels, but it did give a big nudge to refinancing activity. The gains to householders from lower payments will help offset some of the losses to gross net income that will result from the massive decline in dividends the past two quarters. Bonds may provide a substitute, but many will shrink from taking the losses on their (formerly) dividend-paying stocks to switch and anyway, bonds aren’t as simple to buy.
The January trade data showed a decrease in the deficit, but it was all due to the continued drop in total volume. Imports and exports are still falling, and the best thing that one could say about the bleak data is that it was from the month before. Prices continue to weaken (although energy rebounded), but some flattening is discernible. Still, the year-on-year decline in import prices is (-12.8)%. There’s no inflation from imports.
The week ended things with the March reading on consumer confidence from the University of Michigan. While still at very low levels, it was essentially unchanged from the month before. The mathematically insignificant tick upward was given wide coverage in the press, though, because in the context of a market warming to the sideways narrative, it was a victory.
The supply of data picks up considerably next week. Monday is atypically loaded, with the NY Fed’s manufacturing survey, Industrial Production and the Treasury’s report on foreign buying all due out before the open. The Housing Market Index comes out in the afternoon, but with the homebuilders still operating at subterranean levels, don’t look for any improvement in that number. The survey’s data counterpart, housing starts and new permits, comes out the following morning.
Pricing trend data – is it inflation or deflation? – will emerge with the February PPI on Tuesday and the CPI on Wednesday. Fed Chairman Ben Bernanke admitted last week that thoughts about inflation are on the furthest back burner; and we even thought we saw a mildly amused look of incredulity cross his face at the question. Nevertheless, we could see a little action from the volatility in energy prices.
The Fed’s Open Market Committee will issue its statement Wednesday afternoon. In normal times the markets breathlessly await the statement, but with the funds rate sitting near zero and GDP below that, nobody expects any change in policy. The statement will be studied nevertheless for any shifts in the Fed’s singing of the blues, and any chord changes could have a meaningful affect on the current rebound in equity prices.
Ironically, Bernanke may pre-empt the committee with his televised interview Sunday night on the news program, “Sixty Minutes.” Such an appearance is unusual enough for a sitting Fed chairman, but doing it a few days before an FOMC meeting is unheard of. Despite the chairman’s avowed belief in a more open Fed, though, we suspect that the purpose of the appearance is not to chat up policy changes in a public venue, but an attempt to provide some reassurance to the public that the central bank does have a clue.
Wednesday morning, the current account figures will be released. Not being currency traders, we confess to giving this number little attention in the ordinary course of things, but in view of the dollar’s recent strength and its influence on equity prices, it may matter more than usual. More importantly, we think, is that it’s the morning after St. Patrick’s Day: traders could be a little bleary-eyed.
The Philadelphia Fed’s manufacturing survey, thought to be a reliable precursor of the national index (the ISM manufacturing report), appears on Thursday alongside the Leading Indicators. The latter has been pointing upwards recently, thanks to the increase in the money supply, an anxiety-induced widening in yield spreads and some dubious model estimates by the Conference Board. A better indicator is the ratio of coincident-to-lagging indicators, which has continued to sink into negative territory.
The week will end with a quadruple-expiration day on Friday, rendered more intriguing by rumors of trouble with the assets of a major player. The first day of spring should be interesting.
Do things go better with Coke (KO)? Possibly your portfolio might, and we thought that we’d briefly tell you why.
First off, we’re in love with the valuation. We are value dogs, we admit it. We liked it a little better at the beginning of last week, when the stock had fallen to 39 and change, but the darn thing rallied back up to $41.22 by the end of the week. We’ll take it: 4.02% dividend yield, 16.5x earnings (usually trading in the mid-twenties), 13.5 times cash flow (usually about twenty times).
We like the business: drinks, water, juice. It’s got dependable sales growth, and is a great inexpensive trade-up in emerging markets. They let the locals do the bottling and take equity stakes in the operations. The Glaceau acquisition looks good.
We want to tell you the risks, too. First off there is the dollar, currently rising, currently cutting into earnings. But we think that the dollar rally will be over before the end of the year. Second is this quarter: probably the steepest for demand drop in its overseas markets. If market conditions are adverse, Coke might have another sniff at its thirteen-year low of around 37 or so. That’s the near term: we think that by the summer of 2010, the stock will be back over fifty. We also add that it has no finance division, and no worries about its modest debt. It’s Coke, you know what I mean? I think you do.
Avalon Asset Management Company is a Registered Investment Adviser
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