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Avalon Asset Management Company Beware the Ides of May
“Men may construe things after their fashion, clean from the purpose of the things themselves.” – William Shakespeare, Julius Caesar
Yes, men may construe things in a fashion quite far from their purpose. Last week provided some excellent examples, such as the energy market’s tentative retreat from prices based entirely upon speculation that energy demand would increase while it continued to fall. Or the Wall Street strategist for a syndicate book-manager, who contended that last week’s five percent drop in equities showed deep bullish conviction in the face of a record amount of secondary stock offerings. Does that mean a more rational market wouldn’t have bought all the stuff?
A rash of disappointments last week did lead to different constructions. For some, the alternating pattern of larger drops and smaller rebounds showed a market beginning a downward leg. Others claimed that the market had been looking for any excuse to take profits, and that the pause is healthy. Another set were discouraged by poor earnings, a rebound in unemployment claims and the news that thousands of auto dealerships are being shuttered.
Yet on CNBC, one reporter weighed in with the firm conviction that the market hasn’t lost its bullish bias, and he may very well have been right. Markets don’t turn usually on a dime. Although springtime rallies do tend to fade in the latter half of May – hence the adage to sell and go away – there tends to be more of a stutter step about the process.
Many companies report earnings next week, including Hewlett Packard (HPQ), where hopes are rising. If Hewlett can bring in the goods, that could have an impact on how the market views all the retail earnings due out next week. They will certainly be mixed, but the tendency of late has been to focus on the good results and ignore the bad ones. We may yet get a retest of the highs, despite the more frequent talk about a retest of the lows.
During the first quarter, when the crescendo of armchair quarterbacks and short-sellers (hidden and open) calling for nationalization of the banks peaked, President Obama wisely observed that the United States is not Sweden and thus would not attempt to imitate the much smaller country’s experience in turning its banking system around. It was the right approach, and we are certain that time and events will bear out that view.
However, we are now concerned about the auto industry. The relatively muted market response to the Chrysler bankruptcy may have emboldened the government to take one step too many, as evidenced by the statements and insider stock-selling coming out of General Motors (GM). It certainly does appear as if the latter is being readied for bankruptcy as well, and that is a prospect that we look upon with some alarm.
To borrow a phrase, Mr. President, GM is not Chrysler. The former is within a few months of being the world’s largest automaker, while Chrysler is a very distant fifth within the United States. Losing the smaller company is nevertheless going to be painful to the economy, but a bankruptcy filing for General Motors in the current environment is a bridge too far. The latest results for Toyota (TM) – you know, the company with the supposed magic bullets of fuel-efficient cars and no union workers in the United States – fell a breathtaking 42% in April from the year before.
We won’t miss the opportunity to point out that Toyota stubbed its toe in the same way as the other automakers, by manufacturing vehicles that the U.S. consumer most wanted. It wasn’t just Detroit that pursued such a silly strategy. Toyota’s recent manufacturing expansion in the United States consisted of SUV and pick-up truck platforms, whose appeal vanished suddenly with last year’s crude oil bubble.
The celebrated Prius, Toyota’s reigning prince of fuel efficiency, was selling at premiums of four or five thousand dollars to list price last summer. Now they are sitting in undisturbed rows on dealer lots. Toyota’s profit per Prius is about one hundred dollars.
After the crushing blow of gasoline prices tripling last summer, the auto markets took a second hit in the fall when credit markets froze, the equity markets swooned and consumer and business spending went into paralysis. The auto industry had not the littlest finger in any of these events, except to bear the brunt of the consequences (along with the newly unemployed). As our financial system careened drunkenly through the last stages of its binge, the government repeatedly tried the approach of averting its eyes and doing nothing.
That is what led to the current spectacular drop in annual auto sales, and that is what has dealt all the automakers crushing losses. Blaming them is like a drunk driver blaming the pedestrians he ran over for being in the road. The government should acknowledge responsibility for what happened, rather than paper over its role by playing up the traditional complaints of the left (those gas-guzzling Detroit neanderthals) and right (those profit-hating neanderthal autoworker unions).
We did smile at the contrived show of indignation being put on for the benefit of the hedge funds – infamous or celebrated, take your pick - that had purchased Chrysler’s secured debt at steep discounts. Hoping for a killing, they found themselves instead outnumbered by TARP-constrained banks and outpositioned by the President of the United States, who lambasted them as greedy speculators.
Well of course they’re greedy speculators, isn’t that what they charge those big fees for? Still, we don’t blame them for complaining about having their touchdown pass flagged and taken away for illegal formation; we’d be sore too about having that money get away. But if they didn’t know what they were getting into when they bought the stuff, they shouldn’t be playing the game.
Chrysler’s debt sold at a deep discount for a reason, namely the belief that Chrysler would indeed declare bankruptcy. Oops, they did. All this pious talk about contract sanctity and constitutional rights is ridiculous, because contracts can always be chucked out in a bankruptcy proceeding. That doesn’t mean that they will be, because judges usually try to balance the interests of the creditors and debtors, and try to honor seniority in the credit structure so far as it is possible to do so while allowing for a viable business plan. But it’s still a jungle in court, and when one is outnumbered, one is usually eaten.
The hedgies largely knew this, of course, though one can always hope to exhaust or outwit competitors in court and gain a better deal. We suspect that much of the furor has been generated by conservative e-mail campaigns trying to seize an opportunity to make the Democratic president look bad. There’s nothing exceptional about that, standard stuff in the political jungle we’d say, but there is something entertaining about really bad acting.
Last week brought interesting updates on inflation, output, sales and employment. Since we guessed correctly on the inflation data, we’ll start with that first.
Both the consumer (CPI) and producer (PPI) prices indices rose by 0.3% last month, the former at the “core” level (less food and energy), the latter measured overall. But it was an unusually diverse mix of inputs that produced those higher-than-expected results, so much so that it really is difficult to conclude anything besides the obvious fact, or ought to be obvious, that there is no pressure at all coming from the demand side of the economy.
Some price increases are coming from profit-conscious food manufacturers trying to compensate for falling sales, others from revenue-strapped states raising sales taxes with the same objective.
An especially perverse effect is that for the second spring in a row, the Labor department is trying to claim that gasoline prices are falling when they are in fact, rising. The reason is that the Labor Department makes seasonal adjustments to the prices predicated on gasoline demand rising with the onset of the warm-weather driving season. However, gasoline demand isn’t rising, it’s falling, and the price of gasoline isn’t going up because of consumer demand, it’s going up because of financial speculation on crude oil.
The sharp increase in gasoline prices last year led Americans to become very conscious of the cost of automobile travel. Travel fell of course, but the effect changed consumption patterns as well. Rising energy costs pressured food prices, and the combined effect was to push consumers into concentrating shopping into fewer trips and larger stock-ups at discount hypermarkets such as Wal-Mart (WMT) or Costco (COST), especially if they also sold discount gasoline.
Studies have shown that spikes in gasoline prices can affect consumer behavior for years. Last year’s farcical bubble is still fresh in the mind, and the recent sharp increases (for no apparent reason) in gasoline prices are provoking quick pushback in consumer demand. Gasoline supplies fell last week as refiners responded by cutting production, when ordinarily they would be building it. The Labor Department can stand its model on its head and say that prices are falling when they’re rising, but the reality is price inflation due to speculation.
If there is any silver lining, it’s that once the markets come to grip with the fact that the economy isn’t speeding on its way, oil prices will collapse again as speculators flee their positions (Friday’s big drop may be an omen of things to come). Then perhaps prices would fall to the point that people might actually increase summer driving as a way to take vacations. That is, unless refiners continue to cut production. Then we’d be stuck again with the model telling us that gasoline consumption is rising when it isn’t, that prices are falling when they aren’t, and the little white rabbit racing down the hole again with Alice close behind.
Model quirks aside, inflation expectations are low and we can continue to look forward to several more months of year-on-year declines, thanks to last year’s energy bubble: the current trailing twelve-month rate is the lowest in over fifty years. Traders long on gold and commodities and conservatives short on anything Obama does will keep trying to whip up inflation fears from monetary easing and government spending, but they face a difficult comparison battle for the next few months.
Moving on to retail sales, we must confess that our guesstimate of last week was completely off. We thought that Easter and warmer weather would lead to an increase in sales (so did the market, apparently) and instead sales were reported to have fallen 0.4%. We thought that auto sales would hold back the total, but ex-auto, the decline was even worse, at (-0.5)%.
We must ask for some mercy, however. The truth is that total retail sales actually rose by 0.5%, while auto sales fell by 1.8%. But that is the raw data, dear reader. The seasonal adjustments that account for “variations and holidays and trading-day differences, but not price changes” meant that the processed stuff fell while the raw rose.
What’s especially perplexing is the contrast to last year. From March to April of 2008, the raw data showed a total sales decrease of 1.0%, while the seasonally adjusted number (the one everyone pays attention to) showed an increase of 0.2%. This year the reverse transpired. Clearly Easter plays a role, and clearly these seasonal variations are tricky business. We only hope that the Census Bureau models come from a different place than the ones from the Labor Department.
We may be guilty of too much granularity anyway. The statistic that really caught our eye was that February-April 2009 sales combined are 9.2% below the same period for 2008. The economy wasn’t running so hot then either. It looks like the market may have counted a few too many green shoots, but mistaking red for green has ever been a problem for our boys in the production department.
The leveling thesis is still intact so far as the economy goes, it just doesn’t mean that the flight path is going to climb right back up again. The New York Fed reported that regional conditions in May “worsened only modestly.” New orders fell again and are still negative, but shipments and inventories rose. The (-4.6) result was much better than the (-12.0) consensus, but the markets didn’t get excited as much as a week or two ago. Giving due credit, the folks at www.briefing.com opined in a good piece that the “slightly better than expected” view is already fully priced into the market and that “contracting less than expected” has lost its upside punch.
In keeping with that trend, the Fed reported that industrial production fell 0.5% in April. This was better than the consensus outlook for a drop of 0.6%, but once again, it really wasn’t: March, which is probably going to go down as the worst month of the year, was revised from (-1.5)% to (-1.7%). Ergo, the index was supposed to have finished at 97.2 instead of the actual 97.1. Industrial capacity utilization hit a new all-time low for the series (1967).
We wrote last week that manufacturing capacity utilization, running at its lowest rate since the series began in 1947, couldn’t be expected to get any lower. It did drop another tenth of a point to an all-time low, arguably a rounding error, but we’re changing our outlook for another reason. The auto sector problems could result in further deterioration if GM goes into bankruptcy and/or idles its plants, as threatened. There is always the possibility that the government could rescue the number by removing the idled auto capacity from the denominator, but that would be meaningless.
Initial unemployment claims spiked back up in the wrong direction last week, to 637,000, while continuing claims set a record for the 12th week in a row, this time to 6.56 million. The claims may be getting a surge from the Chrysler situation, but all those dealerships that Chrysler and GM are talking about closing isn’t going to help matters. It’s worth noting also that the New York Fed’s regional survey showed declining employment conditions in May: there aren’t a lot of auto plants around New York City.
Consumer confidence rose as expected, largely in keeping with the market rally. It doesn’t correlate well with consumption, but an increase is better than a decrease. The current conditions component actually fell from the month before, something that resonates in the retail sales data and the latest weekly data on mortgage-purchase applications, which remain stuck at very weak levels. The warm weather seems to be helping smaller-ticket items, according to the weekly chain reports, but it isn’t doing anything for home sales. Maybe it’s going to be the year of the small ticket.
Next week swings the spotlight back on the homebuilders, with the builders’ index on Monday and housing starts due on Tuesday. It’ll be a quiet week otherwise. The Fed’s Open Market Committee (FOMC) meeting minutes will be released Wednesday afternoon, and no doubt there will be hunger for more talk of improving prospects. The minutes are always a delicate proposition, with the bank never wanting to appear overly optimistic or pessimistic, so take them with a grain of salt.
Leading indicators through April come out on Thursday, along with the Philadelphia Fed survey of regional business activity. The latter is due for a little uptick, having been at sharp levels of decline for quite some time. Looking at the New York report this week, a big drop in the rate of decline mightn’t be a surprise, though that could be quickly offset by developments in the auto sector. The bond markets will close early on Friday for the Memorial Day holiday in the U.S. (Monday the 25th), and many of their equity brethren will be quite happy to slip out at lunchtime and not return.
StockWatcher will return in a later edition.
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