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“I love you, you love me, we're a happy family." - The Barney Song
We must first apologize to those of our readers who have raised children and thought that they would never have to hear “The Barney Song” again. Yet the warm and fuzzy bonhomie that has descended on the unmistakably bullish traders currently in charge of the tape made the song come to mind many times over the course of the week.
Whether it was shrugging off first-quarter GDP, March personal income and spending, soaring oil and gas inventory, Germany cutting its forecast for 2009 to a loss of six percent, pandemic swine flu, it doesn’t matter. The momentum is higher, and momentum rules. Think green shoots (a phrase you may already be sick of, as are we), mustard seeds, less bad is the new good, and what I’m telling you sir is that this investment is perfectly safe, because as you know, housing prices never decline (wait - was that the old pitch?)
We heard over and over last week that earnings were better than expected. Oh? One statistic frequently trotted out is that sixty percent of companies have beat earnings estimates so far. Sounds nice unless you know that it’s below the longterm average of about sixty-five percent (two-thirds is a good rule of thumb). It’s better than last quarter’s fifty percent, but take it from us, sixty percent is a low number for the beat rate.
What propelled those earnings results were mostly cost cuts that exceeded analyst projections. Mostly overlooked in those results was how often revenue fell short of expectations as well. In other words, both revenue and costs were generally overestimated by the analyst community. But since we’re a happy family, we reward the latter and ignore the former. It’s not the first time that game has been played, and it won’t be the last. All we can say is that it doesn’t work for long, and any recovery isn’t going to be hastened by everybody trying to cut costs at the same time.
The market has now caught up with economic fundamentals, passed them and is trading on the kind of it’s-all-for-the-best outlook that characterizes later-stage momentum markets. Participants can be broken into three camps. In the first group are the professional traders, who have a kind of belligerent confidence that at times gives way to outright euphoria. Not in the least skeptical, they are long for at least another day.
In the middle group are the long-term institutional investors. Unimpressed by the economic data and earnings they are seeing, they still have performance pressure to worry about. In a familiar move, the momentum traders are trying to use that to lure them in.
A theory largely propagated by the traders themselves is that because the long-term investors are becoming anxious and want to buy on dips, they form an invisible floor under the market. Whether or not it’s true, the traders feel less downside risk and are quicker to buy the dips. That’s supposed to have the secondary benefit of frustrating the institutions and making them all the more eager to buy in.
In the last group are the retail investors. Given all the carnage in the markets and the headlines, they are growing more dubious every day at the abrupt turnaround from utter despair to jubilant optimism. Their bearishness is growing with the length of the rally, a development eagerly cited by the momentum crowd and other bulls as contrarian support. Still, some evidence suggests increased participation by day-traders.
It isn’t exactly a secret on the Street that this kind of set-up is typical of bear-market rallies, yet also of bull-market breakouts. The previous two months as good as the last one were January 1991, which started a long rally in the market, and March of 2000, one of the quintessential bear-traps of all time. Many of the professional traders are in fact agnostic about the entire matter, despite what they may say to the press, and are only willing to stick around until the first time a dip fails to hold. There has been much talk in the press that the market is entering a show-me state, but the real question is what kind of event might transpire that could seize the narrative back from the momentum traders.
There is always the possibility that the stress test results to be released on Thursday (maybe) might puncture the balloon, but it isn’t likely. The delays in releasing them have enabled the market to prepare enough for most kinds of ugly, so it’ll take a real hag of an outcome to frighten away the new converts from the financial sector. If swine flu were to become an epidemic, that would loosen the momentum grip, but let us hope that it doesn’t come to pass. The main hurdle visible is the auto sector, with one bankruptcy in and another still possible.
If we had to guess, we’d say that the wave will run the S&P up to 920 or even 950, where there will be no more room for error. The economy doesn’t and won’t support that kind of valuation so quickly, but the eagerness of momentum traders to jump onto things like oil and commodities and bid them up shows how difficult it is for people to leave behind the model of aggressive speculation that has characterized this decade.
Oil data is clearly indicating weak demand and general economic weakness, yet rally fever prompts speculators to leap into such commodities and drive up the price, then turn around and point to the price jumps as evidence of economic strength. The historic farce of last year’s crude oil bubble isn’t even twelve months old, yet we are already back to trying to dress up speculation as industrial demand.
The inventory-restocking story is pretty well known at this point, but until the momentum breaks, traders will celebrate any less-bad data points anyway. Housing isn’t going anywhere, but there ought to be enough bits and pieces coming out of the pause in industrial decline to keep the narrative going for a time yet. The most likely thing to derail the momentum train is itself. Eventually we’ll get too high and it’ll fall apart, but until then there ought to be enough ambiguity to let Barney keep singing.
Housing took a back seat last week, but as it has been at the center of the economic downturn, we’ll review the news from that sector first.
Mortgage purchase applications declined again, and we would say that it was the most important data point of the week. It’s dangerous to extrapolate from a single month, let alone a week, but the trend has been steadily and unmistakably down. Here we are at the end of April with the lowest mortgage rates in history, a glut of houses on the market, prices down more than 30% from their peak, and hardly anybody is trying to get a mortgage to buy a house.
There is some sense to this puzzle. Unemployment is rising as fast as foreclosures, and home prices keep falling. Those make for tough headwinds for demand, something that the lending industry is keenly aware of. Banks have trouble making loans for assets that are falling in value, so they mostly don’t.
The latest Case-Shiller data released for February showed how infatuated Wall Street can get. The 2.2% decline was in line with the current trend and better than the decline of last February, but did represent the fifth consecutive monthly decline of more than 2%. The year-on-year rate of decline “improved” to about (-18.6)% from the previous month’s (-19%), and this was the focus of more Street blather about the economy flattening out.
This is not a sign of strength, but of the calendar. Prices should firm somewhat in the spring as the selling season develops, even in a down economy. The data wasn’t a sign of anything but weakness, especially coming on top of four months of two percent declines. In the data going back to 1987, there had never been any two percent declines until the winter just ended.
However, if the bottom of the housing decline will be thirty-five to forty percent from peak to trough, as many predict, then given the present decline of thirty-one percent, we are nearing the end zone. If we use last year’s seasonal pattern as a reference, the price declines will moderate in the coming months and we will reach the thirty-five percent region in early fall.
If unemployment continues to rise as expected, it will not plateau until the fourth quarter of this year or the first half of next year. Even if home price declines do fade away, rising unemployment will discourage banks from lending into the housing market. Since their write-down assumptions have generally not assumed more than thirty percent declines in home prices, that would mean extra losses for the banks and extra reasons not to lend.
Although a peak-to-trough decline of forty percent is a staggering concept, given the current trends it is certainly within reach. What’s more, an overshoot cannot be ruled out, especially if banks continue their reluctance to lend into the third quarter. The tax credit for first-time homebuyers and low mortgage rates are encouraging buying interest, but they will be offset by job losses. Financing is and will be problematic. We may have reached a bottom for sales rates, but pricing and the industry rate to be weak through the rest of the year. Many, including us, feel that the housing industry may have fundamentally shifted and homes will no longer generate above-inflation returns.
We have been saying since February that the violent declines in production would inevitably lead to inventory shortages that would necessitate some restocking and turn the survey results back upward again “probably by the spring, summer at the latest” ("Circling the Drain," February 20). Right on schedule, the Chicago Purchasing Manager’s Index (PMI) and the National ISM survey showed a bounce this month, with both surveys climbing out of the thirties’ basement to an identical reading of 40.1. Above all, both surveys showed big improvement in new orders. Q.E.D.
The Chrysler bankruptcy will introduce some wobble into the surveys, or we would have predicted another month of improvement. We may still get one, but we have less confidence about what will happen. GM may escape the bankruptcy route – for the sake of the economy we hope that it does – but its talk of idling many plants for most of the summer is bound to have an impact, even on semiconductors.
We also said that any recovery in the surveys would be accompanied by renewed bets in commodities, and that could cause problems. Despite lousy statistics for both oil and gas, both commodities rose at the end of the week, particularly oil, and we saw many a talking head effuse about oil and other commodities. We even heard the phrase, “global growth,” which had us reviving our own, “you’ve got to be kidding.”
The surveys only showed an improvement in the rate of decline. They are still recessionary numbers. We expect some further improvement as the economy needs to restock and the pace goes sideways or even blips up for a time, but this isn’t going to mean a general economic recovery. The Street will try to talk it up nonetheless, as evidenced by the reaction to the first-quarter GDP estimate released on Wednesday.
GDP is at its best a blurry picture of the economy. It showed a decline of 6.1% that was far in excess of the consensus estimate of (-5.0)%, yet the likely-to-be-revised number had panglossian Wall Streeters eagerly bidding up stock futures. It’s all for the best, you see, because the downturn was led by an inventory contraction. Inventories will have to rebound and consumer spending improved, therefore the second-half recovery is imminent and one must buy copper immediately or underperform.
The output tally was also hit by a decline in government spending, and the clever traders concluded that that would reverse too. However, while the federal government is spending more, the state and local governments are not. Neither is the consumer, as evidenced by the personal income and spending report for March that was released on Thursday. Personal income fell 0.3%, while spending dropped 0.2% for the month.
One can expect some help in both categories from the government, though, as tax refunds and lower withholding begin to have an effect. The savings rate increased again in March, but it seems to be leveling off and the extra money in paychecks should help. The stock market is already counting on this, but it has to be set against the effect of increasing unemployment and decreasing credit.
Initial claims seem to be leveling off in the 640k area (last week was reported at 631, but the number is revised upward every week). It’s good that the number has stopped climbing, but claims are still at a very high level and continuing claims have not stopped climbing. The rate of job loss is slowing, but jobs are still hard to come by. The Chrysler bankruptcy will not help the situation. Given the market’s current mood, though, we wouldn’t be surprised to see them dismiss any increase in claims as a passing phenomenon.
Labor costs are still muted. The year-on-year change in employment cost is running at about 2%, or the same rate as the real personal consumer expenditure level. The latter is actually running slightly below the increase in wages, but overall inflation is running ahead. Real incomes are down, and real spending is down. The government programs are going to cushion the lost income from unemployment, but they won’t cancel it out.
Consumer confidence rose, as widely predicted, due partly to the rising stock market, and partly to President Obama’s showing. The former has put a hold on the bold headlines speculating on Armageddon, while the latter’s reassuring delivery and confident manner has undoubtedly helped the public mood. We too were impressed by the presentation he gave on the Chrysler bankruptcy that allowed him to finesse the issue for now. The Conference Board confidence measure bounced sharply to 39.2, while the University of Michigan rose to 65.1, both reports easily exceeding expectations. Even allowing for the low bar, the rebounds were strong (the levels are still low, however).
The correlation between confidence and spending isn’t the strongest, but it’s undoubtedly good for confidence to return and fears for the worst to fade. Down the road will come the unhappiness that results from prolonged unemployment and feeble growth, but that’s a challenge for another time. Factory orders fell more than expected in March, and more than reported (February was revised downward, so the dollar number was a bigger drop than it seemed).
The FOMC (the Fed) said what we thought they would – things are a little better, signs of stability, the economy is likely to remain weak “for a time.” A small dose of carefully guarded, studied optimism was exactly what the Committee should be doling out at this time. Summing it all up, it looks to us that March was indeed a difficult month for the economy and something of a reversal of the previous two months. Confidence, government assistance and depleted inventories should turn April back around, but the levels of activity are low enough that we probably won’t get anything more than a reload.
Next week will put the spotlight back onto the labor market. The April jobs report is due on Friday, and its attendant reports (ADP, Challenger, Monster) will be released in the days leading up to it. While the range of estimates is wide, a loss between six and six hundred fifty thousand is widely expected. Look for the unemployment rate to creep towards nine percent.
Same-store chain sales for April are reported on Thursday, but many of the chains that have struggled the most no longer report monthly data. That leaves an upward bias to the results, which suits the Street just fine. The first half of the week will see the ISM non-manufacturing, or services, report on Tuesday, while a busier-than-usual Monday will see reports on construction spending and pending home sales for March. Productivity and costs, consumer credit and wholesale trade round out the calendar.
StockWatcher will return in a later edition.
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