Avalon Asset Management Company Lexington, Massachusetts Investment Management
Avalon Asset Management Company A Little Spring
"It's not what you pay a man, but what he costs you that counts." - Will Rogers
You know you’ve been living in Bottomville when the gaps between back-to-back weekly gains have gotten nearly a year long. Not only that, but when such an event occurs, it is a Bottomville local ordinance that the gains be universally dismissed by the jaded participants as just another bear-market rally. If a lull in the rivers of blood running in the streets is occasion to start calling for a fresh round of decapitated heads, why then, take heart, investors, for it isn’t until the supply of disasters begins to run out, that observers have the time to explain why we are inextricably doomed. We cannot say whether or not the bottom is just behind us or just ahead, but it is surely near.
Let us begin by pointing out some of the obvious, for that is what is most often overlooked on the Street. Friday’s retreat was not due to fresh worries about the banks, or whether they will lend enough, or whether or not private equity is going to retreat in the face of the AIG teacup tempest. It wasn’t even the brief Manhattan snowstorm that greeted the first morning of spring.
No, the markets were overbought, pure and simple. That has been rare in the last year, and when one adds a quadruple expirations Friday (i.e., many futures and options tied to stock prices were due to expire) a correction was practically predestined. Indeed, but for the Fed’s unexpected money attack on Wednesday, the rally would surely have run out of steam earlier. By week’s end, it was time to take profits, time to push last week’s call options back out of the money. It’s a trading market, and the right trade was the flight trade.
A favored Friday fear, or fearful fact perhaps, was that the banks will not lend the money that the Fed is pumping into the system, but sit on it instead. Of course they are going to hoard, because that is what the banks always do. They chug along until a sector is white-hot, then go crazy and start a free-for-all to see who can make the most bad loans. It’s not their fault, you see, it’s the competition.
When the frenzy invariably blows up, the banks sack everybody involved (thereby guaranteeing that the cycle will repeat itself), and swear off lending until the distressed investors start reporting big profits. Then the banks sack the sober judges who were brought in to preach temperance and start lending again instead. It happens every time. They will lend, just not right away.
Right on schedule, Goldman Sachs (GS) wants to use half of a buyout fund to buy $4-5 billion of distressed debt. What’s more, they’re offering to finance participation by their own employees. I don’t know about you, but I think I hear a bell ringing. While many strained (hoped) to find a juicy scandal lurking in Goldman’s conference call about AIG, we think that the former story was more interesting. When the Goldman Goths start breaking out the vulture suits, it’s time to start learning how to speak carrion.
Certainly, there are hurdles to cross. Earnings for the first quarter aren’t going to be pretty, and corporate outlooks these days tend to consist of drawing a straight line from the last two weeks. If business for the banks continues to improve, it may ironically tempt management to take an extra helping of write-downs, further confusing the market and possibly tempting a few more pens to crank up the nationalization sirens.
Second quarter earnings could be disappointing. The economy is showing signs of going sideways, and is likely to show more signs of stability in the next quarter. Over-eager traders might get ahead of themselves, thereby setting up another downhill ride and reviving the usual recession casting call for preachers of peril, perdition or whatever other end seems really, really scary.
As we have often remarked in this column, the economy is a supertanker not a speedboat, though we might well add that the traders are speedboat pilots. It’s going to take some time to turn, but the first nudges in the course change have been put into place and the next two quarters should consist of turning the ship around. We don’t want to say that it’s all clear sailing, because turning the economy around is a rather large and turbulent undertaking filled with unexpected setbacks. There is every likelihood, for example, that unemployment will not bottom out until the fourth quarter.
Bob Posani, CNBC’s trading joe at the NYSE, made the observation on Friday that traders were wondering if we are out of the global recession yet. We certainly are not. Most of the rest of the world is just a little further up the slope, coming right behind us. It would be perfectly reasonable for the output of the BRIC and other emerging market countries to bottom one quarter after ours, then get a lift from the turnaround in U.S. consumption. Europe might well bottom two quarters later, though some of the countries will surely have a better time of it than others.
In spite of this, we see no reason why the business cycle should be repealed. It may be the case that equity returns are subdued the next few years with no big v-shaped recovery, accompanied by a slower-growth recovery. For some reason, though, the prospect of not having another frenzied run-up in asset prices does not especially disturb us. What’s more, the insolvency plague has so many companies trading at fell-off-the-truck levels that there are quite a lot of returns available to the intrepid.
In the meantime, there are plenty of diversions. The blow-up over the AIG bonuses may be understandable, given the public unhappiness with such recent events as half of consumer equity in retirement plans and homes vanishing in less than a year. Meantime, many Wall Streeters seem to continue to operate in a kind of pre-crash, pre-freeze worldview of “I worked hard all year, so I’m entitled to several million dollars.” One wonders what teachers must make of that.
We would hope that the Street has at least learned that some discretion is in order, because it won’t do to provoke Congress into such gross acts as the ninety-percent revenge tax. The bonus amount may be trivial in the larger scheme of things, or within the scope of the AIG rescue funding, but such things can obviously have outsized symbolic value at the wrong times. Earn-outs might be a better idea for now.
Certainly it is wrong for Congress to be over-reaching into compensation matters, but the Street has seemed remarkably slow to understand that the game has to be played differently when playing with public money. Even CNBC-TV reporters, who are by and large stalwart allies of the Street culture, are throwing up their hands at the Street’s apparent tone-deafness on compensation. It had better get religion quickly, or risk becoming a much less profitable place to work. One argument to drop right away is the one about how business will suffer if one can’t pay up for the best people: the recent track record on that particular theory isn’t very convincing.
The nationalization sideshow debate goes on, with many still arguing strenuously for a kind of public humiliation and show trial that would consist of writing some unspecified chunk of assets – you know, the bad ones, right? – down to zero and then after firing all the management, perhaps flogging them as well. Then some magical transformation happens, because after watching government come in and wipe out the existing equity and bonds (by converting them to yet more equity), some sort of feverish desire to buy more bank equity and bonds is supposed to grip private investors. Uh-huh.
The first thing that would happen if any of the big five were nationalized is that the stock prices of all the others would collapse. Then the government would find itself with at least two or three nationalized banks, maybe four. Maybe only Goldman would survive. The government, still understaffed and overstretched, by universal consensus not very good at managing private affairs, would then by some miracle suddenly get everything right and turn the banks around. This is getting better than Harry Potter.
We understand the desire to get the banks off the front page, or maybe just plain revenge (or being short), but the nationalization-cure myth can be set down with decoupling, global growth, peak oil, the one about markets being prepared for Lehman going bankrupt, and no steroids in baseball. It may be a nice idea and pleasant to believe, but like inter-stellar space travel, we wouldn’t count on it working out just yet.
There’s also the sight of hedge-fund manager Bill Ackman running a major campaign to try to convince Target (TGT) management to get him off the hook with his ill-timed investment. We would argue that Target simply fell victim to a shift in consumption patterns induced by soaring gasoline prices, and that over time the chain should regain it’s “tar-jay” cachet. Mr. Ackman, though, would like to see Target bail him out by spinning out its land to shareholders. In the words of Sponge-Bob Squarepants: Good luck with that.
Our market view remains the same for now: there is still time in the financials rally for very short or long-term time horizons. The intermediate term could get bumpy, though, so keep your fingers on the eject button.
The highlight of the week was the Fed’s unexpected decision to bring up the heavy artillery early: $300 billion for buying long-dated Treasuries, an extra $100 billion to buy GSE agency debt (Fannie (FNM), Freddie (FRE)), and another $750 for buying agency mortgage-backed securities. To paraphrase an old saying, a trillion here, a trillion there, and pretty soon you’re talking real money.
The Fed also widened the TALF program (for asset-backed securities) to include mortgage servicing, leases (in particular vehicle leases), and other loans. Give them credit, the Fed isn’t leaving any stones unturned in its effort to find the springs of liquidity. As to the question of whether it will work, we say that’s the wrong question, because of course it will work. One doesn’t put a couple of trillion into the financial system and bet on stasis. The issues are by how much, and how soon.
Other data seemed to bear out the Fed’s view of the struggling economy. The best that could be said of the data on industrial trends was that they weren’t as bad as feared. Otherwise, they were quite rotten, thank you. The New York and Philadelphia Fed manufacturing surveys continue to record bleak declines, with the former setting a new low of (-38.2). Take heart, it doesn’t go back as far as the 1980-1982 recession.
The Philadelphia reading of (-35.0) wasn’t as bad as the previous month, but keep in mind that the current reading isn’t improvement. It shows a severe decline from February, but one that isn’t as steep as the January-to-February slide. That’s the nature of the beast, because eventually one hits bottom. New orders plunged in both regions, while shipments and inventories fell. It was all pretty horrible, including falling prices.
Industrial production sank (-1.4)% in February, extending the rate of year-on-year decline to a truly gruesome (-11.2)%. Capacity utilization fell to 70.9%, matching the all-time low set back in 1982 (the series goes back to 1967). Like we said, eventually one hits bottom, but the decline was the smallest of the last three months. Consumer goods suffered the smallest drop, consistent with our “stuff runs out” principle that suggests sales declines should begin to reverse. There was also some consolation in that the biggest decline was in utility output, a lumpy series heavily influenced by weather.
The Fed said that it doesn’t consider inflation to be a problem, but is more worried about deflationary tendencies. That was borne out in the regional Fed surveys, which showed sharp declines in input and output pricing, and in the Producer Price Index, which reported sharp declines in prices at the raw and intermediate stages of production. A drop in food prices led to a smaller than expected decline in the overall index, which is down (-1.6)% over the past twelve months.
The Consumer Price Index came in about as expected. Core prices rose 0.2% for the month and are up 1.8% for the trailing twelve months, hardly a cause for concern. Including food and energy, the result was only plus 0.1%. The chance that we will experience another drop in energy prices similar to the one just experienced is remote, of course, but it is hard to make a case for a big rise (unless you’re a hard-money advocate). However the goldbugs and others may fret about the impact of increasing the money supply on inflation, with demand and wages so weak, the Fed’s outlook prevails for now.
There was a whiff of hope in the housing starts data, though not as much as some desperate optimists tried to portray. Starts were well ahead of expectations, but led by an increase in multi-family homes: single family starts barely moved from last month’s all-time low, and the Housing Market Index (homebuilders) remained stuck at the surreal level of nine (fifty is neutral). There was some goofy fretting in the media about a potential pickup in inventories, but the current rate of supply is based upon an unsustainably low run-rate of annual sales. The slightest pickup in the sales rate will mean a big cut in the figure for months of inventory.
February is also one of the lightest months in housing, when seasonal adjustments play a big role, so inferring any kind of trend is risky business. That said, an uptick is better than a downtick, and more importantly, building permits rose as well. We wouldn’t buy homebuilding stocks yet because of solvency concerns, yet concede that current conditions are most likely the industry’s bottom. Even so, until credit conditions improve, we are likely to stay there. The Fed’s work has meant big increases in mortgage refinancing activity, but purchase application activity has the faintest of pulses.
Unemployment claims moderated slightly from last week, but continuing claims pushed on to a new record of 5.47 million. It was only a short while ago that we crested four million; the rate of descent has been breathtaking. We are starting to look for another steep increase in the unemployment rate, possibly as high as 8.5% in the March report.
Despite the weakening job market, though, there continue to be indications that the employed are slowly returning to the stores. Weekly sales are showing steady, if gradual improvement and if the stock market can hang on a little longer, that will further improve consumer sentiment. If equities do have another retest of the lows in store, it may matter less to consumers becoming jaded by the market’s ups and downs.
Another relative bright spot came from the Conference Board’s Leading Indicators. They were down (-0.4)%, less than expected, and last month’s gain was revised downwards to 0.1%. That doesn’t sound so hot, but there are two things to consider: one is that the ratio of coincident-to-lagging indicators managed to eke out a tiny gain. That doesn’t quite qualify as seminal, but it’s definitely better than negative. With March stock prices in line to show a rise, and by extension consumer sentiment, next month’s report might show continued improvement. Just as bad news tends to beget more bad news, the reverse is true for good news. Signs that the decline is fading will hasten its end.
I suppose it would be remiss not to mention the reversal in dollar flows in the Treasury’s International Capital report. Rather than a gain in dollars bought, it was a loss, though one that seemed to have been hastened by money fleeing tax havens in the Caribbean and elsewhere. China is buying less too, but that hardly seems surprising in view of the fact that we are buying fewer Chinese goods. Still, it bears monitoring.
Next week will update us on the housing picture, with existing home sales for February due on Monday and new home sales reported on Wednesday. We think that it will probably be at least another month or two before the Fed’s mortgage efforts begin to pay off in non-foreclosure-related home sales. On the other hand, another couple of months of liquidity work by the Fed going into the middle of the spring selling season certainly isn’t going to hurt. It could slow the rate of decline in prices, leading to some real excitement.
Data on production will arrive in the form of durable goods orders for February on Wednesday, and the last (scheduled) revision of fourth-quarter GDP on Thursday. The latter figure is receding into the distance, but a sharp revision like the last one would have an effect on sentiment. Don’t expect it. Going by the regional Fed surveys, though, you should expect that the durable goods report will be disappointing.
The week will conclude with an update on the consumer. Personal income and spending is released before the open on Friday, and later the University of Michigan presents the first of its two readings on March consumer confidence. The two-week market rally ought to have improved sentiment; hopefully the bonus bombast didn’t cancel it out.
StockWatcher will return in a later edition.
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