Lexington, Massachusetts Investment Management
Lexington, Massachusetts Investment Management
A Month of Mayhem
“If I don't get some shelter, yeah I'm going to fade away.” – Jagger-Richards, Gimme Shelter
Ugly, wasn’t it? It was either the worst May since 1962 (said the Financial Times) or 1940 (the Wall Street Journal). We’re not sure it really matters. It was also the worst month in over a year. All the major indices are down for the year, even the Nasdaq, which - it may surprise you to know - actually rose last week. The long spring rally that culminated in the merriest of Aprils has been wiped off the board.
It wasn’t pretty, either. The “flash crash” of May 6th didn’t exactly raise confidence in the markets during an already difficult time. Here we are three weeks later and would you believe it – nobody is responsible (as predicted here). The official story is that “we’re still not exactly sure what happened.”
They never will be, either. A mantra that unites the Street, from trader to asset manager to broker, is that We Are Not Responsible for Anything That Goes Wrong, Never-Never-Ever. If you think we’re kidding, just have a look at your brokerage or trading account agreement – though we have to admit, the motto applies only to dealings with the investing public. Intra muros, it’s quite another story, with brokers and bankers suing each other around the clock.
Is it really different anywhere else, though? The massive Deepwater Horizon blowup in the Gulf of Mexico has left all three contractors – BP, Transocean Drilling (RIG) and Halliburton – pointing the fingers at each other. That has to be familiar to anybody who’s ever had a problem with their personal computer or IT department – if there’s a breakdown, the one thing you can be sure of is that each vendor will blame the others.
Europe is the same. The Germans blame the Greeks (and their dodgy brethren), who in turn blame the Germans. The politicians and bankers blame the markets for no longer wanting to own debt that seems certain to be devalued. Very unsporting of them. The upshot is that both the ECB and BP spent the month trying desperately to plug big leaks, with rumors that European head banker Jean-Claude Trichet is headed to the Gulf of Mexico to study top kills and junk shots. Burying Greece under a layer of drilling mud must look awfully tempting to him about now.
Things weren’t much better when the market was supposed to be working normally, either (though what a “normal’ market is these days is an open question). The market followed the flash-crash with another reputational low when it sold off sharply on Thursday the 20th in response to the rumor that China might not be happy with its Eurozone bonds. It then staged a massive rally the next day when China said it wasn’t planning on dumping them. We must be impressing the daylights out of the Chinese with our superior Western financial know-how, wouldn’t you agree?
The market itself is partly to blame for its woes. In our column of March 12, (“Rollin’ Rollin’ Rollin”), we warned that the unstoppable springtime momentum would likely bring its own destruction. The too-fast move toward what had been a year-end target of 1250 on the S&P index, we wrote, would leave no room for any deviation from the strong-recovery narrative. It would exhaust buyers and invite government intervention, with a still-unresolved European debt issue waiting in the wings for its next cue.
It’s all come to pass. The S&P 500 reached a peak close of nearly 1220 last month. Institutional cash levels ran down to correction levels, and while some dislike the argument, when institutions run down to 3% or less, corrections inevitably follow. The earnings season was quite successful in terms of results, but the slightest whiff of caution on outlook from company management punished stock prices. There was no room left for error. Financial regulatory reform is on the way.
Government gets part of the rap as well. The European authorities fiddled around too long, and their markets began to burn. Memories of the Lehman Brothers fiasco (“what if we just let it blow up and see what happens?”) haven’t left markets feeling confident that the powers-that-be will be doing the right thing at crunch time. Interest rates and deficits invite worry about how much ammunition is left to fight a crisis.
The growth narrative has taken a big hit. The weekend press is filled with warnings of more corrections yet to come. Those who smiled and rolled their eyes in March at the complaints of bear-skeptic economist Dave Rosenberg are now eagerly soliciting his opinions. The talk has switched from 1250 on the S&P to 950 (currently at 1089, implying another ten percent or so lower).
We might get there. Memories of Long-Term Capital (LTC) come to mind, the black-box genius hedge fund of the 1990s (we seem to recall that the actual number of Nobel economists at LTC’s beck and call was six, but frankly we’re feeling too lazy on Memorial Day weekend to confirm it. It was close to that). When LTC got nailed by the year-old debt and currency problem that spread from Thailand to Russia, the size of the correction stretched to 28%.
But we might not get there, either. Negative sentiment has built up so quickly that the market has gotten oversold and overshorted. Given all the predictions for more mayhem in the media, experience suggests that the markets should instead bounce back up next week. We’re a little skeptical about the very high consensus estimate for Friday’s jobs report, but as we explain below, employment is probably doing better than the claims data suggest. A decent number could generate a big move upward.
The volatility is very unlikely to be over yet, though. Our advice is that if the S&P does fall to 950 over the next few weeks, start buying and don’t stop, even if it drops lower. Although we believe that the rate of growth will be modest in the second half, at those levels the worst case is more than priced in.
Until that happens, though, our recommendation to most is that if you are not watching the screens full-time as part of your job, then stay away from them. It’s not too late to raise a little cash, that we grant you. But the temptation to do something stupid looks set to remain very strong the next few weeks.
May is gone, and good riddance. Try as you may though, you can’t trade yesterday’s market, and you would only lose more money for your pains. Remember that when you open your monthly statements - or better yet, put them aside.
The largest portion of new releases concerned the housing market, though sovereign debt worries kept the sector from rising to the story of the week. It was an especially intriguing week for the disparity between the popular perception, and the analysis by those close to the sector.
The general media tended to wax warmly about the numbers, making it sound as if all is well and on the mend. Just as we predicted last week, all four of the housing reports showed improvement – at least on the surface – and the monthly sales data for new and existing homes both surpassed expectations.
Existing homes ran at a 5.77 million annual rate for April, versus a consensus for 5.6 million, with a 7.6% jump! The year-on-year change was nearly 23%. But the new home sales report used up all the exclamation points for the day. The latest annual sales rate (504,000) ripped past the ridiculously low estimate for 425,000 and represented a near-15% increase on the month. 48% year-on-year! The biggest percentage drop in supply in 42 years!
It may be healthier for the market that the supply run-rate is so low, but before you get excited about the homebuilders, consider that the average number of months a new home is for sale is still 14.3 months, the second longest time on record. Homes completed or under construction both fell to new lows, while building permits plummeted in April – they’re not building a lot of homes this month, either. The annual sales rate, prior to this recession, would still be the lowest since 1982.
Most of the new homes are at the lower end of the market – the median price fell sharply to below $200,000 (about the price of a closet in London) with the proportion of all-cash sales rising. So, nowhere to go but up, right?
The big obstacle facing the industry is the foreclosure phenomenon. Not only are they rising, putting a lot of heavily discounted homes on the market, they are putting a lot more debris on bank balance sheets. Pick up any quarterly filing from a bank and you will see that they all want to talk about how they are avoiding residential construction loans.
It was expected that existing home sales would benefit from the expiring tax credit, but we think that new home sales benefited last month too. Optimists shrugged off any effect on the grounds that new home buyers wouldn’t have had enough time to close, but we cite two contrary statistics: the rising portion of all-cash purchases (they did qualify), and the data on mortgage-purchase applications. After the latter took a spectacular post-credit expiration plunge of 27.1%, they slipped another 3.3% in the week of May 21st. Although the data only go back to 1997, those are record lows. May’s sales data rate to be ugly.
Both the Case-Shiller and FHFA (Fannie and Freddie-backed) purchase data showed seasonal price increases for the month of March, but the unadjusted Case-Shiller prices continue to edge down (and the index people now recommend them). The FHFA data doesn’t report unadjusted data in any place we could find, but with its monthly increase of 0.3% so close to the Case-Shiller adjusted result of 0.2%, we wouldn’t be surprised to learn that its unadjusted numbers were similar to the Case-Shiller unadjusted (-0.4)%.
That was housing; another story that may be misunderstood is employment. It probably isn’t as good as the monthly data, a point that we’ve made steadily, but it’s probably better than the recent weekly claims data. According to the Bureau, actual claims fell by 5,000 over the two-week period from May 8th to May 22nd. The seasonally adjusted data, however, show a different picture of an increase of 14,000. We believe that last year’s steeper decline from the peak is distorting the effect of this year’s slow decay.
Two pieces of data in support of that possibility were the consumer surveys released by the Conference Board (May confidence measure) and the University of Michigan (final May sentiment reading). We were concerned about the impact that the poor stock market performance would have on confidence, but the measure rose surprisingly well, easily beating expectations. A better job market has to be behind the improvement.
The Michigan measured stayed essentially flat, fairly good in light of the stock market. Both readings, however, are still low. A piece of data at odds, though, was the Chicago PMI reading on Friday. It showed a sharp decline in its employment reading. Looking at the unadjusted data, however, we wonder if the case isn’t being overstated in a manner similar to the claims data. That said, looking at the numbers for prices and advance buying, it looks as if the situation is cooling. We suspect a leveling off in the auto sector, a strong regional influence.
The picture of a gently improving employment market was also born out by the April report on personal income and spending. Income rose 0.4%, with the gains coming from the private sector. Spending was unchanged, however, a bit of a surprise. Backing that, weekly chain-store data have shown a substantial tailing off the last two weeks. It suggests that the stock market effect we’ve been talking about - a sharp correction would slow higher-income spending - is real. May retail sales may be queued to disappoint.
New orders for durable goods rose overall by 2.9% in April, but when you took out transportation (mainly Boeing) they fell (-1.0)%, along with private business investment spending (-2.4%). The March revisions were upward and durable goods orders are lumpy anyway, so there was divided opinion on the report. It was consistent with other reports showing an April slowing of the manufacturing boomlet.
Had enough yet? The second estimate of first-quarter GDP came out a downward revision to 3.0% from 3.2%. Much was made of the inventory valuation allowance being responsible for the consensus estimate of 3.3% being off, but for us the two keys were that real final sales were revised down two-tenths and the price deflator bumped up a tick to a 1.0% annual rate. That’s still lower than every other measure of inflation, but at least it’s back in the ballpark with them.
The story of next week will be the jobs report – assuming that Europe can run out of headlines for a few days (e.g., “Greeks Kidnap Merkel, Trichet Promises to Study Issue”) and that BP can manage not to set the Gulf of Mexico ablaze. The consensus is for a rather large 540,000, and if the Bureau can pull that number off it would make markets around the world very happy, census jobs or no census jobs. The unemployment rate is expected to barely move. It’ll make for an interesting day.
The rest of the holiday-shortened week is stacked. Both ISM reports are due, with the manufacturing report coming Tuesday alongside April construction spending and May motor vehicle sales. The service survey comes out on Thursday, along with April factory orders (and a potential tweak to durable goods), same-store sales for May and the ADP payroll report. There will be the other usual teasers to the jobs report and a revision on first-quarter productivity along the way. The earnings calendar will be light; it should come down to Friday.
We happen to like Hewlett-Packard (HPQ) quite a bit at current levels, but there are probably forty or fifty brokerage reports already out there on HP. So we’re going to talk about something entirely different: Bronco Drilling (BRNC) and Union Drilling (UDRL). Both companies are in the business of renting out land-based natural gas rigs, primarily in shale areas like the Barnett Shale. In 2008, when speculation drove oil prices to bubble levels, natural gas went along for the ride, trading over $13 MBTU, compared to $4.37 on Friday. So did the stock prices of Bronco and Union, with Bronco rising to over $18 ($3.65 on Friday) and Union into the low twenties (currently $5.44). Bronco traded north of $30 in 2006.
Of late, there has been lots of press about the supply situation in natural gas ramping up due to developments in shale drilling and LPG production. The US suddenly has much more natural gas than previously thought, and there is talk of a global surfeit of gas.
On the other hand, the price of gas is near all-time lows when adjusted for inflation. Demand for gas suffered major hits in the wake of the financial crisis, as speculators fled and industrial production cratered. Yet the supply-demand picture for the near term appears poised to turn in favor of land-based natural gas.
The economy is recovering, albeit slowly. That will help drive demand. The summer of 2010 is expected to be a hot one, which traditionally drives increases in demand and price. The situation in the Gulf of Mexico for the rest of the year may be quite favorable for the land-based drillers, as the combination of what is supposed to be an above-average hurricane season and a moratorium on drilling projects could cut regional production significantly. Every time a hurricane begins to move into the Gulf, natural gas prices move up.
These two companies have taken the big writedowns and are trading near the bottom of their historical ranges. Although currently squeaking by, they are still cash-flow positive, with lots of leverage in a rising-price environment. A rise above $5 MBTU would be helpful; a move towards the decade average of around $7 would mean a real boost to profits. Both trade at steep discounts to book, with Union at 60% of book and Bronco at less than a third.
Mexican zillionaire Carlos Slim is a major shareholder in Bronco, and banks he controls have a warrant to buy up more stock at $6.50 a share, up to 19.99% of the company (the exercise price rises to $7 in the fall and $7.50 next year). We don’t see a $6.50 as being a significant short-term drag to a $3.65 stock price; if you do, then you shouldn’t be reading this. You’re either too dumb or too rich.
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