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“The fool doth think he is wise, but the wise man knows himself to be a fool.” – William Shakepeare, As You Like It
Like leaping gazelles who assume that if the other fellow is jumping, it must be a good idea to start high-stepping yourself, the U.S. markets sprang up last Monday when the Indian stock market ignited. The latter explosion was the result of election results bringing India’s reform-minded, freer-market National Congress party into power with a clear mandate, resulting in a 17% increase in the major Indian indices.
Suddenly global growth was back on the menu again. It wasn’t much of a success the first time except as a marketing concept, but on the Street sizzle is often more revered than the steak. Asian growth was dialed in as a given again, India is ready to rock, and it probably didn’t hurt that the previous week’s U.S. loss had set us up for a rebound.
Since we wrote five weeks ago that the market was roughly at fair value (April 17, “Springing Forward”), the S&P has thrashed its way about two percent higher, with all of the gains coming from the first two weeks. As the “not bad is good” chorus has aged, the rally has faded for lack of a clearer path to growth. Prices are still roughly at equilibrium, but like nature and vacuums, traders don’t like equilibrium. They need action.
We certainly got action in the currency and energy markets. Since the major U.S. banks first announced in April that they foresaw a profitable quarter, the feeling has taken hold in the markets that the American financial authorities are determined to avoid any further systemic breakdowns. That sense of protective safety, along with the rebound in the equity markets, has helped reawaken an appetite for risk.
The predilection for risk-taking doesn’t quite appear to be firmly entrenched yet, but it is sufficient to divert money out of the safety trades – Treasuries and the dollar – and back into volatility. With lending for leveraged investing still highly problematic, the futures markets – where contracts are intrinsically leveraged – have become the markets of choice for the aggressive trader.
Policy-makers should take heed of this development. At the beginning of the decade, very low levels of interest rates led to leveraged investing as a way to garner acceptable returns. Success begat imitation, begetting more imitation until it became a one-sided trade fed by torrents of money, ending in the spectacular blow-up with which we are all so sadly familiar.
In the case of oil, it managed to settle up a little over $61. We estimate that about $20 of that is due to OPEC supply cuts, about $20 due to financial speculation, and about $20 due to actual demand. That’s right – if you took away the speculators, oil would be in the forties, and if you took away the cuts, it’d be in the twenties. Demand is down and has almost nothing to do with the current price.
Of course, whenever oil makes such a move as the recent one – up fifty percent since its low in March – the speculators and position-talkers will try to flood the press with self-serving twaddle. The oil business is so large, for example, that it’s a fact of life that there will always be a refinery glitch of one sort or another going on somewhere. But when prices are moving sharply higher, industry routine gets hyped into market-moving events.
In a way it’s true, because when momentum fever hits in any market, all tidbits can be potential market-movers, banal as the events may be. It’s also true that price creates its own reality. Contention over the control of such an essential resource as oil is a fact of every oil-producing country. At times the struggle can get nasty. Let oil prices take a big move higher, and disputes can get nastier in a hurry. A barrel price of $100 attracts a lot more trouble than $10.
The press will dutifully report such struggles as driving prices higher, but aside from helping traders create further hysteria, it’s the price increases driving the battles, not the other way around. Remember that the next time you hear some talking head solemnly going on about some guerilla group threatening oil supplies – the price isn’t really going up because of the guerillas, the guerillas are there because the price is going up.
So goes the dollar story. When the financial system started coming apart last fall, the flight to safety generated a terrific rally in Treasuries and the U.S. dollar, such that Treasuries were the most over-valued asset class in existence by the end of the year. As the desire for safety has faded, so has the desire to own either object. Money is flowing out of Treasuries and the dollar into more interesting places.
A side effect of any big move is the nonsense narrative (one is tempted to call it the knucklehead narrative, but that would be unfair to the former), such as last year’s oil bubble and its gravely delivered hokum of peak oil. A new brand of snake oil reaching for the prize this year is the proposition that the dollar’s fall is due to the “left-wing” economic policies of the current administration. Free-market investors are running for cover, you see.
This story, which is starting to get quite a bit of press play, ignores a couple of crucial facts. One is that the most aggressive of our economic policies are being set by the top echelon of the Federal Reserve. Largely moderate Republicans, none of the group has been appointed by the current administration.
The other overlooked bit is economic reality. Currencies such as the euro and pound come from regions with far more government control and “left-wing” bent than our own, yet have risen strongly against the dollar. Don’t investors know that they should be fleeing them? The Australian dollar benefits from the commodity trade, and the currency most often mentioned as the potential successor (someday) to the dollar, the Chinese yuan, has the most avowedly socialist, government-controlled economy of all.
Still, one has to write something and the potential failure of the dollar is an easy source of purple prose. The Standard & Poor’s placement on credit watch last week of the British pound was occasion to throw around some more gravitas about the deficit. Why anybody would take the rating agencies seriously anymore is a good question, because nobody on the Street does. Having gotten caught handing out ratings for cash, the agencies are now trying to recover their reputation by rushing to downgrade anything that makes the front pages.
One should throw the U.S. ratings-downgrade worry into the same dustbin as peak oil. It isn’t going to happen. The built-in leverage in the futures markets, however, could be problematic for the recovery. With most other forms of leverage shut, those markets could attract more money that they can handle. It bears thinking about.
As for equities, they are likely to continue pinging about between 820 and 920, with the odd foray or two beyond those bounds to keep us from getting bored. The bullish bias is still intact, but the near-complete lack of visibility into the future gives us conviction that the markets are more likely than not to test the limits of the range. When that happens, remember that ultimately real earnings decide prices, not theories, and that the real economy drives earnings. Happy Memorial Day (Monday) to our American readers.
The week began with data from the homebuilding industry. The Housing Market Index, the homebuilder sentiment survey, reported an increase on Monday to the lofty levels of 16. Since a reading of 50 is neutral, one might be forgiven for thinking it’s actually a bad reading, but it was an increase from 14 the month before and met the consensus, so for a day it fit the v-shaped recovery narrative.
That narrative took a wobble the next day when data on housing starts for April were released. Housing starts fell again to a new, post-World War II low of 458,000 annualized while permits dropped to 494.000. Both numbers were well short of the consensus, and both were distorted by an unusually sharp swing in multi-family housing. On the single-family side, starts and permits posted modest increases of a few percent. In aggregate, though, both permits and starts are down over fifty percent from last year.
The market wasn’t cheered by that news, because a continuation of the rally needs stories that, however awkwardly, fit the v-shaped narrative. The news does have a bright side that some analysts were quick to point out, though, namely that the less new-building activity there is, the sooner the massive inventory of unsold homes will be cleared out. TV guru Jim Cramer went so far as to boldly predict that accelerating foreclosure activity would speed the economic recovery.
Adding less supply to an oversupplied market should be a good thing, though we can’t deny a reflexive cringe at the thought that this proposition has been served up steadily since the fall of 2006 as a reason to buy homebuilder stocks. It’s bound to be right, someday, though. While the falling activity should benefit the longer-term balance, in the near term reduced builder activity reflects lower economic output, more unemployment and less disposable income.
The latter part is important, because while the sharp price drops and low interest rates do stimulate buyer interest, the size of the pool of qualifying buyers must also be taken into account. That pool is still small, perhaps smaller than some realize. It is fenced in by extraordinarily tight lending conditions – reflected in the sharp drop in multi-family units, where financing is nearly impossible – growing unemployment, and falling home prices.
Even if prospective homeowners aren’t daunted by the prospect that the value of a home may fall another ten percent after purchase, the banks certainly are. Despite that, current conditions should eventually be overtaken by pent-up demand, but there is substantial evidence to suggest that that time is still some ways off. Refinancing activity is brisk, but mortgage-purchase activity remains at very feeble levels. Applications fell again last week, when they should be rising at this time of year.
The housing puzzle will get some big pieces next week, when price data (Case- Shiller on Tuesday) and sales data (existing home sales Wednesday, new home sales Thursday) are reported. The Case-Shiller data is for March, while the latter two reports are April figures, so there will be room for interpretation (and confusion).
In a similar vein of mixed signals were the FOMC (Federal Open Market Committee, the Fed’s main policy group) minutes released from the last meeting. The statement itself didn’t represent much of a change, being the usual mix of caution and guarded optimism, but the markets weren’t pleased that the Committee revised its economic projections downward for this year and next. While the Committee’s forecasts haven’t exactly been clairvoyant the last couple of years, the market had to wonder what they were seeing that made them take down their outlook.
Oddly enough, the Fed’s staff saw things differently, and revised GDP projections upward for the second half of 2009 and 2010 (those revisions weren’t released). It’s perhaps not surprising that the minutes and accompanying summary made many references to an unusual degree of uncertainty amongst the participants. The Committee’s observation about empirical analysis showing that financial-crisis recessions are longer and deeper than the average probably didn’t cheer anyone, either.
Weekly retail sales weakened again, and though it’s only a week, the deterioration was rather steep. Weekly jobless claims improved to 636,000 from a revised 643,000 (actually reported as 631,000, but they add another 5,000 every subsequent week so we thought we’d get out in front of them).
However, continuing claims continue to mount, reaching a level of 6.65 million. The pace of increase in the latter is slowing, but how much of that is due to claims being exhausted and falling off the back end remains to be seen. Jobs are tough, and they are going to get tougher. There is some talk about discounting additions from the auto sector as a temporary phenomenon not indicative of the real trend. In other words, when the unemployment rate hits ten percent, it won’t really count. What a lucky break.
It wouldn’t surprise us either to see the markets rally on the back of a ten percent unemployment rate, on the theory that it can’t get much worse, or even that it must be the trough. That might be close to being the truth, too. But not getting any worse isn’t the same as getting better. The Philadelphia Fed business survey came in at (-22.4), a slightly less steep decline than the previous month, but bigger than expected. That didn’t fit the smooth recovery narrative and left the markets in a funk for the rest of the day.
But there was a bright spot in the form of the leading indicators report. The report showed that the leading indicators rose 1.0%, which was better than generally expected, but also that the ratio of coincident-to-lagging indicators rose, which is often thought of as a signal that the recession is ending. Whether it holds true to form, and what shape the recovery might take, remains to be seen.
Besides the housing data, next week will also bring a Conference Board reading on consumer confidence in May. Coming out on Tuesday, it will be book-ended by the University of Michigan’s final May reading on Friday morning. The stock market rally should help both readings.
Durable goods orders in April are due out on Thursday. The consensus is for an unchanged reading to up half a percent, but most of the survey data that month showed declines in new orders. Maybe they were just kidding. The first revision of first-quarter GDP is due out on Friday, with some improvement expected from the original fall of 6.1%. Bulls will key in on the inventory data, hoping to see a big drop that will presage a rebound. The Chicago PMI for May rounds out the holiday-shortened week.
For Memorial Day, we present a couple of names that may seem unexciting to the average investor, yet make us quite happy.
Regular readers know that we like to plug the virtues of preferred stock now and then. Last year’s crisis had many financial-related names trading at levels we didn’t think possible, as panic swirled around names such as Goldman Sachs (GS) and Morgan Stanley (MS).
The preferred stock of those two companies has recovered quite nicely, but there are still some great opportunities to be found. Two that we present to you this week are courtesy of companies that are no longer publicly traded: Merrill Lynch and Countrywide Financial.
Both of those companies have been taken over by Bank of America (BAC), but the preferred stock lives on, paying handsome dividends. One was issued by Merrill and trades on the New York Stock Exchange under the ticker BMLPRI (BMLI if you look it up on the Wall Street Journal site – preferred stock symbols vary from service to service), while the other, issued by Countrywide and similarly traded on the NYSE, goes by CFCPRB (CFCB).
The Merrill preferred is currently yielding 11.8%, while its Countrywide cousin is throwing off 11.4%. Both Merrill and Countrywide are said to be two of the strongest contributors this year to B of A’s bottom line.
As the belief has taken hold that Bank of America will not disappear, these two names have rallied strongly. Unlike the common stock, which has also rallied, there isn’t any dilution risk with the preferred. They nearly always benefit from capital raises. The dividend is fixed, unlike the common, and while the bank has the right to skip dividends, to do so is tantamount to default, so a bank that wishes to survive at all will not do it. We believe that the risk of default is minimal.
Anything financial is still susceptible to some bumpy weather in the weeks and months ahead, so either buy carefully or be prepared for some volatility. As the crisis ebbs, though, we think that the yields will return to levels similar to those of Goldman and Morgan preferred, implying the possibility of significant capital appreciation. There are worse things to do with your money.`
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