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“If it were done when 'tis done, then 'twere well it were done quickly.” – William Shakepeare, Macbeth
It’s that time of the year when one must confront the old adage: should one “sell in May and go away?” We would say that as the S&P approaches the 950 level (or higher), you should get more aggressive about exiting long positions. That doesn’t mean that there’s any need to fight the momentum trade: the Street loves nothing better than short-squeezing rallies when the market is supposed to go down.
But the season is getting long in the tooth. Like most springtime rallies, it’s been largely based on optimism about best-case scenarios that lie a magical six months down the road, aided by improving weather and the well-known fact that markets usually rally in the spring, so ride the rally.
The problem is that much of Wall Street is eagerly awaiting a return to the once-in-a-century profit levels we experienced in the last few years of the housing bubble. But we’re not going to rebubble this time. The rebound from the insolvency abyss has been exciting, but that momentum is nearly exhausted. After an inventory restock – almost certain to be modest - margins and earnings growth should return to more traditional paths.
But it’s going to be a long road even to get back to those levels, no matter how many times one may close the eyes and say, “China.”
One of the things that public companies have to disclose in their filings is the existence of any customers that individually make up more than ten percent of revenue. This is to inform investors of the potential risks in being dependent on key customers.
It seems that we are about at that stage now with China. The Chinese stock market is up 50% from the beginning of the year, articles are appearing about the rebirth of decoupling and despite doubts about the validity of some of the Chinese statistics (see below), it appears to us that the current fashion is to straight-line a one or two-quarter Chinese stimulus program into the infinity horizon.
But China’s economy is forty percent export-based. It isn’t all going to the United States, of course, but if the U.S. isn’t humming, it seems foolhardy to assume that China is going to hum. It’s fine for them to take advantage of reserves and stock up on some commodities while prices are low, but a stimulus program isn’t going to offset the sharp decline in orders from big customers like the United States and Europe. It looks as if the fast money is going to be slow to adapt to a slower growth environment.
Pimco’s Mohammed El-Erian underscored some of the difficulties about the outlook for the rest of the year. While allowing for the inventory bounce, their analysts are finding it difficult to say what might stimulate demand in any meaningful way down the road. In the interim, there is the risk of dollar-holders chasing commodity prices as a hedge against the falling dollar.
In the short term, the commodity chase (partly a dollar hedge, partly a chase for leveraged trading profits) can contribute to the kind of warm and fuzzy outlooks that traditionally make up part of the Wall Street spring fashion show. The price increases are driven by speculative financial bets that the world might look okay six months from now. Holders of long positions then cite the price increases as proof that the economy is recovering, though the increases have nothing to do with actual industrial demand
This kind of game can be self-defeating, however. With our rather fragile inventory rebound, a sustained run-up in prices that is unrelated to demand – especially true in the oil market – is going to slow the real economy. A genuine order-book underlying a price push provides a layer of support that enables input users to pass on price increases. The absence of one tends to end in a sudden collapse of prices.
Let’s review the situation. On one side, we have housing prices continuing to fall, unemployment rising, energy prices racing back up prematurely (further hurting profits) and a probable General Motors (GM) bankruptcy filing on Monday. Outside of one or two stories like Apple (AAPL), the technology sector has mostly provided revenue shortfalls and disappointing guidance, while retailers report falling sales and no more guidance.
On the other side, we have momentum, charts, the hopes that the economy might bounce for some undefined reason, and the theory that any incipient recovery requires pouring money back into commodities and emerging markets.
As you’ve probably guessed, we don’t buy it. Momentum is a powerful force in the market and must be respected as such; it does little good to burn money trying to fight it. But momentum that cuts against reality always comes to grief in the end.
The markets get ahead of themselves by forgetting that economies change slowly, and shorts lose money by forgetting that Wall Street tends to ignore the blinking warning lights. But when it hits the wall, it still comes to a halt. Traders and investors like to believe that they can guess the last second to jump. Most of them get it wrong.
We read last week that the government is pumping yet another $50 billion into GM. Regular readers know how we feel about this: the government’s reluctance to put up “many more billions” of taxpayer money to guarantee a Lehman Brothers sale has resulted in trillions of dollars in damage control. The auto and home sectors have borne the brunt of the damage from that disastrous misstep. We cannot say it any plainer: no Lehman bankruptcy, no GM bankruptcy.
Now the government is tired again of spending billions, this time on GM, and appears ready to take its chances on a bankruptcy. It may very well be that a managed process, unlike the Lehman filing, makes all the difference. But we don’t like it. We especially don’t like the thought that we may repeat the process of a trillion-dollar damage bill that came from trying to save some billions. Cross your fingers, and maybe your toes as well.
The heart of last week’s data was the state of the housing market. It began with the latest update in the Case-Shiller home price index, which reported no letup in price declines through the month of March. Old data, said the market. We’re looking ahead now, just like the consumer (the Conference Board reported another leg up in consumer confidence the same morning).
That was followed by the report on existing home sales. Expected to grow by 2.0%, the April increase was reported to be 2.9% – thanks to a large downward revision to March (without the revision, a 2.4% gain). However, most of the luster was immediately clouded over by revelations that inventories climbed back up to over ten months of supply (10.2), that the annual rate of price decline was up over 15%, and that the non-conforming market (essentially mortgages over $500- 700k) has a 40-month inventory of supply at current sales rates.
There was some improvement in the mix: the percentage of sales made up of foreclosures fell to 45% from over 50% in March. Yet mortgage-purchase application activity is still very weak as we enter the fat part of the peak selling season. After the foreclosures have been swept up by cash buyers, then what? Financing is still unavailable, unemployment will be higher and prices will have fallen.
When foreclosures do decline, that will ease pressure on prices. But by then the peak season will be over, while the delinquency rate is still rising. It’s difficult to make a reasonable case for a rebound in housing to occur before next year. New-home sales were reported to have risen, but the “increase” to 352,000 was short of estimates and due entirely to a downward revision to the previous month: originally reported as 356,000. Changing March data to 351,000 enabled the improvement.
A similar pattern happens with weekly jobless claims. Last week they were reported to have fallen 12,000, a number achieved by comparing the previous week’s upward-revised number (643k) to the current preliminary number (631k). We told you that the number was really 636k because it gets revised upward by about 5,000 every week. Sure enough, it was reported this week to be 636k. Did anybody report that last week’s fall was 7k rather than 12k? No, they reported that the current drop was 13,000 by pulling the same trick – comparing the upwardly revised number with the yet-to-be-revised 623k, which next week will be reported to be 628k or thereabouts.
Look at the durable goods report. The Census department reported that new orders rose 1.9%, beating expectations. Except that they didn’t. Based upon March’s original report of $161.2 billion, new orders should have come in higher than that level to meet or beat expectations. Ah, but March got a walloping revision downward to $158.4 billion, so the April report of $161.45 billion was reported as a 1.9% increase instead of an 0.2% (actually 0.155). It’s not a decline, which is good, but the point is that the headlines are constantly inflating what is actually happening.
Last month, for example, markets cheered the 0.8% decline in new orders for durable goods because it was so much better than the (-1.8)% estimate. It turns out now that they fell 2.1%, much worse than the consensus. Interestingly enough, there’s been a spate of articles recently that pose the question, is China overstating its current GDP rate and perhaps fudging government statistics? All we can say is – well, duh. Good to see them learning how to be a top-tier country, isn’t it?
Cheekiness aside, we doubt that our economic reports are being cooked by the government. We suspect that the primary reason is that estimation models used by the various agencies haven’t caught up with the changes in our economic structure. It takes time to update those correlations.
That’s understandable - we can think a lot of prominent commentators who’ve been stuck singing the same tune for thirty years. It’s still not uncommon on the Street to go around quoting fantasy writer Ayn Rand’s fifty-year old period pieces as investment guidebooks (they’d be better off with Lewis Carroll). It takes time for the Street to adapt to structural shifts, and many never do.
As for jobless claims, continuing claims continue to rise at a disturbing clip. They are now at 6.6 million, another new record. At the current rate, unless there is a serious increase in expiring benefits dropping off the back end, we will crest seven million by mid-June. Next week’s jobs report should let us know how that we have lost over six million jobs (net) since the recession began. That will put us at the six-and-six level (millions of jobs lost, millions of continuing claims). Seven-and-seven looms ahead in the July report.
The improvement in the Conference Board’s confidence number was due almost entirely to optimism about the future outlook. That is helpful, but we will again make the point that six-month-forward surveys are lousy predictors. The University of Michigan’s confidence index came in slightly ahead of consensus, at 68.7. Much like Tuesday, the market chose to ignore the bad news (the Chicago PMI) and focus on a fairly weak piece of good news.
The first-quarter GDP decline was revised up to a decline of (-5.7)% versus the original report of (-6.1)%, but the markets didn’t seem to care much. The Chicago survey showed an alarming pullback from the previous month, dropping all the way back to reading in the low thirties (34.9). New orders and employment suffered big declines. The Philadelphia report was weak as well the previous week, and that would suggest a weak national ISM report on Monday. But Monday will be the first day of the month (a far better indicator of profits, surely), so traders will probably be in rally mode.
Next week brings the monthly big Kahuna again: the jobs report. Surveys and weekly claims reports point towards another weak report. Can the market possibly stage yet another rally off a weak number? The Challenger layoff report and ADP payroll-based estimate will give the markets time to get used to Friday’s actual report, so anything is possible. If the market does rally, we suggest taking a little bit more out of the market. The estimate stands at about 530,000 at this point, but by Friday morning it will have been unofficially revised to account for the earlier reports.
Besides the ISM manufacturing report on Monday, we’ll get a report on motor vehicle sales, personal income and spending, and construction spending. Pending home sales for April are announced on Tuesday, while factory orders for April come out Wednesday. We expect the false bounce syndrome to continue: March will be revised lower, making April look better.
The ISM non-manufacturing survey for May comes out Wednesday, while May same-store sales for a few chains will be reported on Thursday. The latter will probably include another announcement or two that the retailer in question has elected to stop reporting monthly sales. It won’t be because business has been so good.
Stockwatcher will return in a later edition.
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