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Avalon Asset Management Company Raging Bull
“What are you trying to prove? What does it prove?” – Joe Pesci as Joey LaMotta in Raging Bull (Martin Scorcese)
The standoff between overbought and overworried continued in the press last week, but there was no such standoff in the stock market. The recovery from the intra-day March 9 low (666) crept toward 40% last week, an astonishing move for a two-month period. The strength of it has pulled in performance-conscious managers trying to buy volatility on dips, while frustrated short-sellers keep coming back for more. As one trader put it after the close on Friday, “eventually this is all going to end poorly, but for now the trade is on the long side.”
The word in the press is mostly doubt about the rally, and rightly so: the economic fundamentals have barely improved and the length and strength of the rally have been extreme. Bulls continue to point to media skepticism as contrarian evidence, but the press doesn’t trade the market. Bullish sentiment measures rose sharply last week, and there is no mistaking the tilt of traders. The second-half recovery is nearly a done deal.
This is typical May behavior, dear readers. Springtime rallies usually peak between the middle of May and the end of the month. You can almost set the calendar by them. Lest we seem complacent, though, we warn you that there does lurk the occasional outlier when the “sell in May” mantra gets overdone. The market loves the in-your-face counter-trade that catches sentiment badly overloaded to one side, and now and then plays the defiance card into June. Then it blows up in July.
We said that the markets would push to 920 or even 950, and at a tad under 930 we’re almost there. The main obstacles for the markets at this point are first, they are overbought, and second, they are well ahead of fundamentals. That blather about the second-half recovery is the usual type of after-the-fact stuff ginned up to justify a rally, but that really isn’t what the market is trading on right now. It’s momentum, pure and simple, and momentum is powerful. Short interest is still relatively high, and there hasn’t yet been a massive upside day that would indicate seller capitulation.
Make no mistake, we will see another painful correction between now and the end of the year. Most likely it will come between now and the end of July, and the more the market moves up, the more rickety the underlying structure. The technology sector has begun to weaken, and that is usually a warning flag. Advertisements for trading systems are proliferating again on the television market channels.
Yet the markets do have a tendency towards perversity, and the testosterone division could push for 1000 on the S&P or 9000 on the Dow just to prove themselves. That would not be good for the markets overall, because the economy isn’t going to come close to justifying that price so soon, and the eventual letdown and loss of faith would be sharp. It could end up postponing a genuinely sustainable advance until late into the year.
But as Lord Keynes remarked - we love to cite this one - the markets can stay irrational far longer than you can remain solvent. Take some profits, by all means, and be careful about stepping in front of this tape. It could crack any day, perhaps tomorrow or perhaps two months from now, but the coming of that day is known to no man.
In the meantime, the government is mulling over what kind of regulatory structure it wants to have for the financial sector. There will no doubt be much wailing and gnashing of teeth to accompany the predictions of the end of free markets and capitalism. While that goes on, it appears that the Fed has the inside track for getting some kind of super-regulatory mandate for overseeing systemic risk.
Whoever ends up with the new rod and staff, more supervisors will not produce any lasting difference. We’ve made the point before that the markets didn’t lack the ability to regulate in the last bubble; it lacked the desire to regulate. We can pass rules now that limit the amount of leverage an investment bank can use, for example, but another administration could come along down the road and undo them. The Fed may presently be in the mood to watch capital ratios and lending standards, but ten years from now a different regime could prevail.
We suggest that some additional limits be put into law. The financial markets shouldn’t be precluded from innovation or run by government fiat, but legal limits on systemically dangerous practices are harder to overturn than agency rules that can be easily voted in and out. It took about seventy years to overturn Glass-Steagall, for example. There is no magic bullet. Even institutional memory can fail quickly, as the short trip from the tech wreck to the housing collapse and credit crunch illustrate. Yet laws are more difficult to repeal and rewrite.
In the midst of the celebrations about the economic recovery – prompted by a mild easing in the rate of decline – states are dealing with serious tax receipt shortfalls around the country. This is significant, because taxes are hard data. They aren’t surveys, they’re not seasonally adjusted, and they represent real time economic activity. These tax shortfalls indicate that economic activity is weaker than the markets would have you believe.
The outlook for the European recession has also gotten worse. Yet return-hungry investors are pouring money into emerging markets, which are now up fifty percent from the March low. They are doing so less out of any conviction in the countries than out of a desire to chase returns. Eight up weeks in a row has brought back the raging bulls. One wonders if the market remembers anything at all from last year, other than that the trend is your friend – until the end.
We may as well begin with the end of last week, because the jobs report is the big kahuna. The loss of 539,000 jobs was noisily feted on the Street as more evidence of the magical turning point (along with the obligatory two seconds of silence in memory of the fallen unemployed).
The chest-beating was boosted by the fact that the estimate had been for something perhaps just north of 600,000, though that number was no longer real-time by Friday morning. The ADP payroll report, backed by Challenger (layoffs), Monster and weekly claims, had lowered market expectations such that some were guessing at a number well below 500,000. The futures market actually fell somewhat when the number was initially announced, but the result was no match for the daylong parade of bellowing bulls.
As George Soros remarked a few weeks ago (and we a few months ago), the economy couldn’t stay in free-fall forever. The two-quarter contraction just experienced was the sharpest since the Great Depression and some leveling off was bound to occur, so long as we weren’t tied to a gold standard and had a central bank that provided liquidity rather than take it away, as was the case in the Depression.
So the rate of job loss has slowed, as expected, and that is better than no slowdown. February and March were revised higher (but the revision rate slowed!): it turned out that March lost 700,000 jobs after all. The private sector did indeed lose more than 600,000 jobs, 611,000 according to the Labor Department estimates, but the hiring of contract workers for the 2010 population census resulted in the awesome, recovery-inspiring beat.
Most sectors of the economy continued to lose jobs at a sharp pace, but not as steeply as March, which seems to have been a peak contraction month. In an indication of the restocking process, there were upticks in overtime and the workweek in manufacturing: exactly what one would expect from a sideways move in the economy. Hourly earnings were unchanged, while the unemployment rate jumped to 8.9%. One wide-eyed bull proclaimed this a great success, as the rate of increase is slowing. Yes, as the number gets larger, the same jump will be a smaller percentage. That’s some hard-working analysis for you.
Despite this great victory, we expect that the unemployment rate will continue to climb towards ten percent. This is widely expected, of course, but tossed aside with the observation that unemployment is a lagging indicator. True enough, and we too expect that monthly job losses will continue to moderate. This does not necessarily mean that the economy is improving, but that we are reaching an equilibrium point. Typically unemployment overshoots that point (hence the lag).
Despite all those raging bulls projecting a straight-line improvement from here to infinity (and they are proliferating rapidly on the Street, if not in the press), we beg to differ. The domestic economy has been anemic since late 2006, but the symptoms were long masked by the real estate and credit bubble that allowed American spending to pump up emerging markets and stock market traders to pump up asset prices. We bought consumer goods from the emerging markets, and they bought heavy equipment and technology from us. It’s going to be quite some time before that gets going again.
At the end of the last recession, very low interest rates led some bond money managers to employ unusually high amounts of leverage to generate investor-friendly returns. Early success in the mortgage-backed arena was quickly copied, and the stampede was on. The housing market was already rising going into the recession, and when investors hungry for returns pumped increasing amounts of money into the sector, like every good bubble it was a source of jobs, spending and paper wealth that fed consumption.
This time the credit markets are going to remain tight, housing is moribund, and it’s difficult to see where demand is going to come from. The testosterone solution is to cite China again as the big motor, but China’s centralized way of doing things has translated into an order surge that isn’t going to be repeated in the absence of Western consumer buying.
There was wild excitement over the first decent PMI number in nine months coming out of China last week, but we don’t know what else could be expected with the central government putting the stimulus money to work in what is essentially a two-month injection. Public spending projects help, but are not sufficient to turn an economy around, as the Japanese experience demonstrated.
Weekly jobless claims moderated to just over 600,000, still a very high number, but an improvement over the 640k rate of March. Continuing claims continue to mount to 6.35 million, and the number of jobs lost in this recession now amounts to 5.7 million. We should hit the six-and-six level in next month’s report: over six million jobs lost, over six million in continuing claims. The latter may stretch to seven, but even with federal extensions, claims benefits have a time limit and run out eventually. It would not surprise us to see claimants begin to drop off the back-end as benefits are exhausted, and then traders hail the “improvement” as more evidence of a recovering economy.
The last industrial capacity figures reported the lowest such activity rate since the data began being kept in the 1940’s. We can’t go no further, as the locals sometimes say, without slipping into a depression.. That possibility is diminishing with the amount of stimulus and liquidity added to the system, so weekly claims should continue to moderate. That’s not recovery, though. It’s stagnation.
In keeping with the leveling thesis, the ISM non-manufacturing rate of decline slowed, with the survey reading rising to 43.7 from 40.8 the previous month. The survey respondents hardly sounded positive, complaining of tight credit conditions and weak customer demand. There were also some cautious guesses that the worst may be over. We expect that it is in terms of decline.
The week got off to an exciting start with the news that pending home sales increased 3.2% in March, an increase I saw being used as a stick all week by bulls. It was most misleading. Pending sales did increase in the South and West, but fell in the Northeast and Midwest. What’s happening in the first two regions is that distressed property sales are increasing as homes selling at 25% of loan value are being snapped up. This isn’t so much a sign of confidence returning to the market as it is a sign of seller capitulation: those prices weren’t available six months ago.
Such sales do help to clear off the glut and must precede recovery. But extrapolating the crowds at a going-out-of-business clearance sale to annual sales rates is mistaken, as the falling sales in the rest of the country demonstrated. Weekly mortgage-purchase applications remain at very weak levels despite record low mortgage rates, the arrival of the peak selling season and widespread price declines.
Construction spending ticked up 0.3% unexpectedly where a decline of about one percent had been expected. Call us cynics, but we’re skeptical about the positives of this report. Residential construction declined at the usual rate, and the Labor Department reported 110,000 job losses in construction for April. That’s on top of 135,000 lost in March, more than double the monthly rate of last year.
The reported increase in office outlays – seasonally adjusted – may have been a blip driven by a handful of deals. It isn’t clear to us why such construction would be increasing as the office market tanks across the nation, or why the market might need increased supply. We suspect a few projects managed to complete financing or break ground, but wouldn’t look for support from this area.
In other data, weekly chain-store sales have flattened at a rate that is up from the first quarter but still slightly negative from last year. The Easter phenomenon seems to have run its course, but was largely forgotten on Thursday when the thirty-four remaining companies that still report monthly same-store sales announced results. In brief, the higher end is still getting worse, department stores still struggle, the low end is generally okay and hot teenage concepts still bring in more shoppers.
Wal-Mart (WMT) reported a very good month – can you say, “Easter?” – and announced that they would no longer report monthly sales. It was smart to go out on a high note. Combining March-April sales in order to eliminate the Easter effect, chain-store sales were up 0.5%, or after adjusting for inflation, something less than zero in unit terms. Retail sales for April will be reported next Wednesday; the Easter effect and higher gasoline prices should add to the number, while auto sales may subtract. The consensus is for flat to (-0.1)%, but that looks to us like another deliberately low setup.
Wholesale trade inventories fell by 1.6% in March. As it appears to be the peak decline month of the quarter, we look for similar drops in March business inventories and international trade to be reported next week.
The latest readings on producer and consumer price inflation are due next week, with the PPI coming on Thursday and the CPI on Friday. We suspect that trouble may lay in the total numbers: the rally in equity markets has also produced a buying surge in commodity index funds, driving up prices despite the lack of any industrial demand. In our February 20 column, "Circling the Drain", we warned that the demand for trading profits would resurface before industrial demand, and that the herd would stampede back into commodities when the economy began to move sideways.
This is now happening, though our wished-for tightening of trading requirements and disclosure has not. The resultant commodity inflation will be blamed on Fed easing, but it won’t be the classic relationship of more money chasing goods. Rather, it will be the modern relationship of more financial players chasing more beta (risk).
Friday is a loaded day in a back-end-loaded week. Besides the CPI, we will get the N.Y. Fed survey on regional manufacturing activity for May, and the central bank report on industrial production in April. The latter should show a rebound from the depressed March levels. The University of Michigan will also report its first May reading on consumer sentiment, and we look for continued improvement there too, thanks to the market rallies.
StockWatcher will return in a later edition.
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