Lexington, Massachusetts Investment Management
Lexington, Massachusetts Investment Management
Are We Having Fun Yet?
“You're in then you're out, you're up and you're down.” - Katy Perry, Hot 'N Cold
“Europe Bailout Lifts Gloom,” read the headline in the Tuesday Wall Street Journal, the morning after a little 404-point bonfire in the Dow Jones torched short positions mercilessly. Four days later, “Europe Clouds Recovery” declared the Saturday edition of the same paper, which followed a day and a half of near-relentless selling that resulted in back-to-back triple-digit losses. If that doesn’t inspire the retail investors to come back into the market, what will?
That’s not all of it. We watched Wednesday and Thursday with a certain sense of amazement as the small cap barometer, the Russell 2000, already up five percent on Monday, ran up over three percent from Tuesday’s close to midmorning Thursday for no apparent reason that we could see. Then it plunged, falling over four percent over the next twelve hours of trading before leveling out in Friday’s last hour. Was that all because of Europe?
It reminded us of a long-ago week, namely the Three Mile Island nuclear reactor catastrophe. That was when the headlines started out the week along the lines of “Fire Produces Minimal Damage, No Threat Seen” and ended with “Thousands Flee.”
We had guessed that after the previous week’s debacle, the short-squeeze trade that had been the backbone of the spring rally had finally been broken. You certainly couldn’t tell that the first two-thirds of the week, though. It looked like the Street had gone right back to its favorite game, leaving us to ponder whether we had once again underestimated the sheer mindless power of the working momentum trade.
The Europeans came through with a rescue package that exceeded almost everyone’s expectations, a massive package designed to wipe out the doubters and stop talk of contagion. It worked for a few days, but a few things came together on Thursday to send the black boxes cranking in the other direction (one might be excused for suspecting that the morning rally on Thursday was a deliberate head fake).
To begin with, Cisco’s (CSCO) earnings report, though quite decent, didn’t deliver the blow-out guidance that the market seemed to crave. It’s been a fairly typical reaction of late, especially in big tech, and CEO John Chambers didn’t deliver a ringing endorsement of the economic recovery. That was a bit of a drag on the sector, but the quants were cranking up the prices anyway when the S&P hit its 50-day moving average.
Technicals matter a great deal these days, and when the 30-year Treasury auction got a lukewarm reception right afterwards, suddenly everybody started talking about Europe again. Maybe the package will lead to austerity, huh? Gee, do you think? The talk and tape went red.
It’s reminiscent of the fall of 2008, when Congress finally got its act together and passed the stimulus package to stop the hemorrhaging in the markets. That got the markets back up again for a time, but eventually they slid to new lows and didn’t recover until the financials could break the short momentum some five months later.
Perhaps Europe will fall into the same gravity trap of being guilty until proven innocent for some months. The question for the U.S. market is whether or not it would get dragged down as well by Europe, and the answer would be, “probably.”
But probably later than sooner, because that’s the way the markets work. Breakdowns like the one we’ve seen recently rarely send the markets on a straight slope down. In fact, hardly anything does besides a genuine recession, and even that has to smack the market around quite a bit before it sinks in. Right now, we’re not in a recession.
The markets will continue to chop for a while yet, that’s almost certain, yet these episodes tend to fade over several weeks’ time. We’ve warned you about getting whipsawed and that flag is still flying, but the markets are now much less likely to be wrong-footed by fears about European countries and their debt.
No, a European slowdown-to-recession has now been largely baked into the present market outlook. What’s more likely to happen is that the markets will keep oscillating, but less and less with every week that goes by without the end of the world.
Although we may indeed move to a “new normal” of lower growth (it says here that we will), it isn’t going to materialize definitively over the next few weeks. Economic data will continue to show improvement, year-over-year comparisons will still be positive, and earnings growth will keep being reported. The markets will probably begin to forget their fears about the European slowdown and bulls will tell us why it won’t happen. Why it simply can’t happen.
Then in the fall, the problems will become evident again and we’ll have another go in the funhouse. Oh well, maybe Katy Perry will have another album out by then. As for next week, keep in mind that an awful lot of puts have been snapped up in the last two weeks and Friday is an expiration date. That usually means a deliberate push back up as we get closer.
“Mortgage applications rise 3.9%” said the nice headline. Gee, that was pretty impressive, what with expiration of the tax credit and all. The catch was that weekly purchase applications fell (-9.5)%, with the overall increase being led by refinancing applications.
The drop was deeper than the (-5.0)% experienced in the first week of last October, when the tax credit was last thought to be expiring (this time there are no signs of an attempt to renew it). Purchase applications fell for six weeks in a row after the last expiration, but this time we are entering the peak selling season rather than the off-season. That may mitigate the decrease. Maybe.
April retail sales data beat expectations, both with the overall increase of +0.4% and the ex-auto number of +0.4%, but analysts were quick to pick it apart. The gain was led by strength in auto sales and building garden supplies, with the latter most likely a one-off tied to the expiring homebuyer tax credit (that should be good news for the two leading home supply stores reporting next week – see below).
Yet most categories showed weakness, and the strong auto sales data seemed dubious to many. For our part, we have noticed a consistent pattern over the last couple of years of retail sales data reporting better than expected results that are later revised downward - but only many months later. For example, looking at sales for October of 2009, the unadjusted results have now lost half of a percent off the annual rate from the original announcement, but the adjusted results have been revised a tenth upward. Oh?
We certainly don’t say that the Commerce department is cooking the books, but there does seem to be some favorable bias and some counter-intuitive adjustments being made, at which many an economist has railed. Nevertheless, the combined March-April total was reasonable and it looks to us that the sales environment is steadily improving. Weekly retail sales data indicate that spending is holding up. The comparisons with last year are still bound to be favorable, becoming more difficult as the year wears on, but that should be expected.
The rub is that the improvement isn’t coming from income gains, and employment remains weak. People getting those new jobs in the census and manufacturing areas, as well as census, must certainly be spending some more money. But something north of 1.7 million actual people lost their jobs in April (unadjusted and allowing for the two-week waiting period), and they are surely not spending more.
A factor frequently cited is “strategic mortgage defaults”, meaning people who have stopped paying their mortgage in the belief that banks are full up with foreclosures right now. They may be right, and not sending in any payment at all may also be that the only way to get the attention of most assistance programs.
However, we think that most of the extra spending has been coming from the top income percentiles, where unemployment has stayed stronger. Their spending power far outweighs the pack, and their confidence has been restored by an 85% rally in the stock market over the last twelve months, including a very robust April.
That’s quite a wealth effect, and the sense that the government will not let the financial system go to pot is also quite important. If the stock market does suffer a correction of substance, say fifteen to twenty percent, we think that we’ll see a real slowdown in the headline spending data.
A supporting fact is the consumer sentiment and confidence data. The University of Michigan’s sentiment measures haven’t budged this year. The latest May reading of 73.3 is below the recovery average and well below the long-run average. As we like to point out, the well-to-do only get one vote in the surveys, but lots of votes at the cash register. The labor market may be improving, but it’s still grindingly difficult, running at record levels for long-term unemployment and near-record levels of applicants per job.
Businesses are still unsure and that’s reflected everywhere, from the widespread CEO caution expressed this earnings season about the recovery, to the softness in employment and inventory data. Cisco’s John Chambers was typical of most CEOs: very willing to talk about good his own company is positioned – have to protect the stock price - but unwilling to say the same about the economy.
They’re voting with their dollars, whether it’s in employment or goods, as the inventory data released for March showed last week. Yes, they are increasing, which is good and should result in a small add to the GDP revision. Both the wholesale and business categories were up by 0.4%, nice except that the builds continue to run below sales, with the inventory-to-sales ratios making new record lows every month. Manufacturing is definitely picking up, but the data make it plain that businesses are reluctant to commit themselves.
That could work to advantage. If retail sales remain relatively stable, goods production will be obliged to increase faster than the current rate of expansion, which would benefit both employment and headlines, and above all the national mood. It would, however, also slow down the rate of profits increase.
There is still plenty of slack in the economy, as the latest Industrial Production report made plain (April). Capacity utilization is inching upward at a painfully slow rate and now stands at 73.7%, 70.8% for manufacturing. The long-run average for both is in the low eighties, and manufacturing utilization rates are still below the lows of the last two recessions. At least there’s plenty of room for improvement.
However, production did increase a stronger than expected 0.8%, led by big increases in mining and construction, with the latter posting its second big increase in a row. We’d be remiss to point out a potential benefit to all of this. Much of Wall Street has been banking on, or outright promoting, a recovery arc that is probably not going to be as steep as advertised. Our view is that the slower pace will lead to disappointment in share prices.
Yet a recovery in which capacity utilization and inventory rebuilding grow slowly may prove to be more sustainable. The current makeup of the Street doesn’t really favor that, with too much of the machinery geared to trading and/or creating volatility, and chasing 20%-plus annual returns. A smaller model built around slower-but-steadier growth would be healthier, though, and might slim down our excessively large financial sector.
Import-export prices showed sharp increases as international trade increased. Most of the increase in imports is in petroleum prices. Oil inventories are near all-time highs and rising, yet prices are thirty percent higher than a year ago, despite the recent big drop that took them down from fifty percent higher. Gasoline inventories are over 4% higher, demand is only 2.7% higher, yet prices are nearly 25% higher. Even the Journal has thrown in the towel and now reports the heavy financial speculation in oil as simple fact (the editorial page may be another story).
Next week will bring the latest on inflation and homebuilding. The CPI comes out on Wednesday and the PPI, tipped to be higher by trade prices will come the day before, though consensus is for very little change in both indices.
On the homebuilding front, the builder sentiment measure (“Housing Market Index”) comes out Monday afternoon followed by April housing starts the next morning. It’s reasonable to expect at least a little uptick from both measures, since the warmer weather and expiring tax credit meant a favorable tailwind.
The sentiment index will probably rise about 20 for the first time in over a year, which should create some excited headlines. Neutral, however, is far away at fifty. The homebuilder stocks are coming back into fashion again, and the next few months will probably see them get well ahead of reality, creating an opportunity for some good short sales.
The FOMC minutes from the last meeting will be released Wednesday afternoon; Thursday brings the April update of the Leading Indicators and the May business survey from the Philadelphia Fed. With the yield curve unchanged and the strong stock market performance in April, look for another big number from the indicators. Manufacturing job gains suggest that the Philadelphia survey should post a good result as well.
It isn’t the most exciting schedule, really, although surprise results can always make such predictions look bad. The focus should be on earnings then, with some real market barometers reporting: Lowe’s (LOW) on Monday, Home Depot (HD), Hewlett Packard (HPQ) and Wal-Mart (WMT) on Tuesday and many other retailers throughout the week.
Now, an ETF that turned over more than 42 million shares last week isn’t exactly unknown, so you may be wondering how we can call it a secret. The reason is that is that the long Treasury bond has been so far off the radar screen of most of the big or “smart” equity money, that it might as well have been a secret for most of 2010.
Last December, we were thinking about ways to go short Treasury bonds, like nearly everybody else on the planet. Come January, though, we started having real doubts about the idea. That was when we realized that indeed, everybody else on the planet had been thinking the same thing. Poll after poll revealed the near-universal consensus opinion that the one place you did not want to be in 2010 was long Treasury bonds.
That made us step back, because if there’s one place we don’t like to be, it’s on the side of the universally accepted trade. No sir, not for us. So we brooded, and two points emerged from the mist. One was that upon reflection, we had to admit that the outlook for a pickup in inflation through the rest of the year was looking ever more doubtful. We now lean towards the minority view that by year-end, the 10-year yield is much more likely to have a three-handle on it than a five (or less glibly put, yields will be below 4% rather than above 5%).
The other point was not a guess – in times of trouble, the favored haven is still the stuff backed by the U.S. Treasury. When the doubts about Greece first started getting mainstream coverage back in January, it occurred to us that if it or any other part of Europe fell down, or for that matter China or even the U.S. stock market took a tumble, the first place everybody would head for would still be the warm and liquid embrace of U.S. Treasuries.
Therefore, as yields rose toward 4% on the ten-year, we began to buy the TLT as a hedge on the market. What a nice change it was to be getting paid to hedge for a change, as the TLT is yielding a bit more than 4%. No options decay, no inverse tracking issues, no short-position dividends or interest to pay out.
If equities rise, the TLT weakens, but the monthly interest payments take some of the sting out. When equities retreat, the TLT strengthens – and you still get those dividends.
True, it would have been better timing to have written about TLT two weeks ago, when we chose to feature Goldman Sachs (GS) instead. Sorry about that. But we think that adding some Treasuries to your portfolio whenever the market starts to get complacent won’t hurt you. Our thinking on this point got some confirmation just a few weeks ago when we saw the latest “Big Money” poll results in Barron’s: everybody’s least favorite place was still Treasury bonds. That’s the kind of affirmation we like.
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