Avalon Asset Management Company Lexington, Massachusetts Investment Management
Avalon Asset Management Company How Green is My Rally?
"Thus bad begins, and worse remains behind." - William Shakespeare, Hamlet
There was some good news last week – not only did the markets rise for a third week in a row, but nobody wanted to believe it. A steady succession of talking heads faced the cameras and solemnly announced the futility of just another bear market rally. The AAII investor sentiment reading became more bearish, portfolio managers expressed doubt, and an investment conference we attended on Thursday found no believers.
Such high levels of doubt are promising, if only for a while. A rally that must pull in unbelievers leaves less room for disappointment. The end of the quarter looms, threatening to bring in more money reluctant to miss the best month that the market has had in years. Though it is mostly a case of relief that the economic decline isn’t limitless, traders don’t doubt the rally.
Any doubts that their sentiment has turned were put to rest on Wednesday. Monday’s 500-point rally was lovely, ignited by Geithner’s public-private-partnership template, accelerated by a bump in existing home sales, and topped off by short-squeezers smelling blood. But it was Wednesday’s turnaround that seemed more impressive, as the markets’ initial gains and more were wiped out in the early afternoon. For most of the last six months – possibly with the exception of early December – we’d have sold off all the way into the close, but this time the market righted itself and closed with a decent gain.
The weakness was brought on a tepid Treasury auction, worrying observers about the ability of governments to sell debt. We would say that the lukewarm response was a reflection of the improving news of previous days, and an indication of risk-taking coming back into market. While many markets are yet ill – there are still no mortgage-backed securities done without an agency guarantee, and the current 19% yields in the high-yield market are keeping that market mostly shut – some are doing a banner business.
The market for top-quality investment-grade corporate debt is sizzling right now, and California, which couldn’t sell anything back in October (though neither could anybody else), found itself obliged during the week to cap a strongly over-subscribed auction for its own bonds. Bond market mavens have been raving all year about the great deals in corporate and municipal debt, not to mention government-backed mortgages, and it would appear that recent events have led to some mass conversions to the fold.
One of the major factors in government bond yields of late has been raw fear. The flight to safety drove yields down throughout the fourth quarter to ridiculously low levels by the end of the year. Everybody knew that it couldn’t last, but it isn’t easy to shake off a period like last fall, when every security known to markets but Treasuries was thrown out the window.
Have you ever seen one of those National Geographic shows on wildebeest migrating across Africa? When the herd comes to a river, the wildebeest in front don’t just leap joyfully across the water. They stop and look at it with one of those “this wasn’t in the brochure” looks on their faces and appear to be deeply wishing that they had taken the other fork back there at the two bushes. The herd piles up on into them, though, pushing the front-runners into the water, who then cross out of the desperate urge to get back out of the water and onto dry land as fast as possible. Once they get across, everybody follows. Wall Street isn’t much different.
It’s perfectly normal behavior at this point in the cycle for investor demand for safety to wane. The migration towards higher levels of risk and return are early votes of confidence in the economy. It’s inevitable that government yields rise off their lows in order to compete, and it’s just as inevitable that the usual lot will start to loudly screech that this is a sign that the world is running away from U.S. debt because of the senseless policies of our government that will leave us all bankrupt and our children in beggar’s prisons, et cetera, et cetera. It’s always a good story line. The main difference this time is that the story will not be as well-suited to wrapping fish as it once was, what with the Internet and all.
The Armageddon crowd tried to buttress their case with the China story, where bank governor Zhou Xiaochuan wrote an article on the dollar that probably qualified as one of the largest attempts ever seen to have one’s cake and eat it too. It seems that the Chinese have woken up to the fact that if they keep selling us boatloads of stuff, they are going to end up with boatloads of dollars in return. What a rotten deal. What’s more, the currency is going to fluctuate – who knew? – and they may end up with lots and lots of dollars that they can’t just dump whenever they want without affecting the price. Outrageous.
That was some egregious book-talking by the Chinese, who find themselves in the position of every fund manager who ever accumulated a huge position only to discover that the exit is much harder than the entry (see Ackman, Bill). It’s always a nasty moment when one discovers that one has become the market’s default buyer - who is going to buy from you?
We fear that that the Chinese government may have grown too accustomed to having its way with its tight management policies. Faced with these unruly currency markets and the crazily unmanaged dollar – what are those Americans thinking? – they have started pining for a world reserve currency that can be reset by governments. Rather than quote Sponge Bob two weeks in a row, though (i.e., “good luck with that”), we want to help and so we propose a solution to the problem: raise your prices and sell your stuff somewhere else. Your dollar problem will go away, we guarantee it. Just ask Russia.
Despite the Chinese wishes for a more stable process, we are likely in for a bumpy ride this year. The economy was not so bad as the March low, but it isn’t yet good enough to sustain a genuine bull rally. The most likely prognosis for the next six months is the kind of struggle that characterizes the transition from bear market to bull, from recession to cyclical rebound. It’s hard to see how the emerging markets can escape the effects; perhaps the Chinese are having the same difficulty of vision.
The saga of Bernie Madoff took a little vacation from the headlines last week, and we can’t complain. Yet we observed that investigators have reported locating over a billion dollars so far of assets once controlled by Madoff. That compares to the sixty or so he was supposed to have had. We couldn’t help but notice the leverage ratio – it looks to be about forty to one or so. Wasn’t that the same problem Bear Stearns and Lehman Brothers had? Too much leverage and not enough cash to meet the calls. There’s a lesson there somewhere.
The news of the week was surely the data out of the housing market. Two positive surprises, one in existing home sales and the other new home sales, hit a market ready for action. It was time to buy first and ask questions later, of which there were many.
Let us begin by saying that an uptick is better than a downtick, and repeat our opinion that existing home sales are near the bottom (“the” bottom, we leave to others). Home prices are still falling though, as yearly price declines deepened to (-15.5)%. February is one of the slowest months of the year, meaning that seasonal adjustments play a large role in the eventual number, and about 40- 45% of the sales are distressed sales, led by foreclosure bottom-fishers in California.
The supply of homes for sale increased by five percent, but the higher sales rate kept the months-of-supply inventory figure intact. There is a great deal of “shadow” inventory on the market, homes with ready sellers that aren’t being listed in the current environment. Any strength at all in sales or price stability is going to be met by rising supply.
New home sales increased as well, helping Thursday’s stock market turn in another big rally. Yet the same caveats apply: prices continue to fall, and seasonal adjustments loom large. February sales were still below December, and are a rebound off a January that was the worst month ever, with the successor month the second worst month ever. “Time to buy the homebuilders!” is the rallying cry on the Street, yet if you had shorted every homebuilder rally in the last three years, you’d have made a fortune.
One day the homebuilder rally will of necessity finally be right. Traders will nod wisely and talk about the importance of buying the stocks before the turn, omitting the twenty or thirty failed rallies on the way down. Note the action in KB Homes (KBH) on Friday: the news that the company beat estimates by over six cents sent the stock roaring ahead ten percent in morning trade. It’s the right kind of mood on the Street for that kind of headline, but we realists would point out that company revenues were forty million dollars short of estimates ($307 mm vs. $347 mm estimated), that the company lost seventy-five cents a share rather than the eighty-one estimated, and that the company’s CEO declared that “we currently see no meaningful improvement in market conditions for the remainder of this year.”
Another grain of salt on the subject: the Mortgage Bankers’ Association continues to report very weak levels of mortgage purchase activity. Refinancing activity is quite brisk, lending credence to the rumors that Bank of America (BAC) is reaping a bonanza this year from its Countrywide Financial unit, but there are no signs of life in purchasing. The index stands 34% below its level of a year ago. Next week will bring the Case-Shiller price index and the February pending home sales report. We’ll place more importance on the former, but in any case it’s going to take more than a month’s worth of seasonally adjusted data to give a clear picture.
The markets knew what to make of the positive surprise in the February durable goods report, rallying strongly off it and the new home sales report. We are glad to see the string of six consecutive decreases finally come to an end (a record in case you’re wondering, but the data’s begin date of 1992 means that it only spans one other recession). The report also supports our “stuff runs out” theory that cutbacks were so severe that we were due for some imminent replenishment. New orders rose 3.4%, and excluding transportation were up 3.9%. Private capital investment excluding transportation rose 6.6%.
That’s all to the good, and we’ll take it. But we’d have felt a lot better about the report if December and January hadn’t been given some big downward revisions. The new orders category still stands 23.4% lower than a year ago, and we fear some disappointment may lay in store for the markets. Our view is that durable goods will probably return to the lumpy pattern that prevailed last year, up one month and down the next, before the Lehman bankruptcy froze the credit markets and sent us into the tailspin. That’s a big improvement over six down months in a row and is the path to better things, but a downtick next month risks drawing an overreaction. Time will tell.
The final (scheduled) revision to fourth-quarter GDP revealed that it fell 6.3%, an insignificant change from the previous estimate of (-6.2)% and better than the consensus estimate of (-6.6)%. It’s still quite a ways off from the original estimate of a drop of 3.9%, but why bring up the past? Inflation is very muted, something we already knew. Now it’s official. Corporate profits fell back to 2004 levels with a 36.3% drop, the largest since 1994.
Unemployment continues to rise, with initial claims at 652,000 and continuing claims rising steeply again to 5.56 million. The consensus estimate for the March jobs report next Friday is for a loss of 650,000, but we don’t doubt that whispers of a million will circulate. The consensus does look too low to us. The Labor department’s births-and-deaths model adjustment might save the day, but our guess is something north of 700,000 with upside risk. The estimate for the unemployment rate is 8.5%, which looks about right.
The deteriorating employment picture was reflected in the personal income and spending report. Personal income fell, real personal income fell more, and real expenditures fell as well. Income was also revised downward for December and January, although January expenditures were revised higher. The details were depressing, as every industry but government contracted. Inflation was slightly higher than thought, together the two reports started the markets off on the wrong foot on Friday.
The deteriorating income picture might have affected the University of Michigan’s consumer confidence report, which did show an uptick from the previous month, but only a very modest one that left it still well below sixty (something in the eighties is more typical). The Street was probably hoping for better, given the improved tone of the market and economic headlines; perhaps the better tone will show up in the Conference Board’s confidence measure that is due to be released on Tuesday.
In addition to the employment, housing and confidence reports due next week, we will get considerable data on production from the Chicago PMI (Tuesday), the ISM surveys (manufacturing on Wednesday, non-manufacturing on Friday), construction spending (Wednesday) and factory orders (Thursday). Motor vehicle sales are also due on Wednesday, the heaviest day of the week datawise and a popular day for pranksters. That should lead to a rather large dose of groaners from the media.
The jobs report would ordinarily overshadow all else, but expectations for the surveys are set low enough to be beatable, while the jobs number looks sure to be worse. It’s conceivable that a newly hopeful market might try to rationalize away the jobs report if the other data is good and jobs aren’t too awful. In addition, Fed Chairman Bernanke speaks later on at a credit market confab, so if the jobs number is only reasonably ugly, it might get a little less attention, making a fourth up week in a row within reach. We’re not really hopeful about the true employment picture, but the jobs report is, well, a horse of a different color, as the gatekeeper of the Emerald City might say.
We are in the camp that likes investment-grade corporate bonds this year, and for this reason we suggest you turn your eyes to two closed-end funds that specialize in them.
Pimco Corporate Income (PCN) and Pimco Corporate Opportunity (PCY) are the two funds we have in mind. Pimco, the country’s best bond manager (so say we) is the manager of these two funds that use leverage to enhance their returns.
Like many other bond funds, PCN and PTY have issued auction-rate preferred securities to achieve leveraged returns. Unlike most others, until recently Pimco had declined to redeem the now-unpopular securities on the grounds that it would damage the shareholders.
Recently, though, yet another swoon in bond prices, especially financial ones, put the two funds in violation of asset-coverage covenants. The funds were obliged to suspend dividend payments until the ratios could be brought to proper levels again, and they did so by redeeming some of the auction-rate preferred.
That suspension set the prices of the funds plummeting, and while the dividends have since been reinstated and fully paid, the prices have not yet fully recovered. With yields over fifteen percent, we don’t think that the situation will last long. The prices should rise until the yields are at less generous levels, adding to the returns of shareholders.
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