Lexington, Massachusetts Investment Management
Lexington, Massachusetts Investment Management
A Tale of Two Streets
"You're wrong when it's right, it's black and it's white." - Katy Perry, Hot 'N Cold
We are certainly not the first or only observer to comment on the divide between sentiment on Main Street and Wall Street these days. Barron’s carried a fairly sardonic piece by Randall Forsyth remarking that any tide lifting all the boats isn’t being felt by “the galley slaves.” Individual investor polls are showing strong bearish sentiment, while professional readings show a bullish tilt. Unemployment has hit its highest level in twenty-six years, yet the sale of yachts seems to be picking up (leading us to pose that venerable saw of Wall Street – “but where are the customers’ yachts?”).
The jobs report was disappointing again, and as usual the market managed to talk its way around it. After all, the locals were having a parade to celebrate the 27th baseball championship for the city’s pinstripe-wearing millionaires, a feat that was probably responsible for more than half of the rise in the Dow last week. Some things matter more than others.
For example, companies have learned that it is no longer necessary to grow sales or earnings to be rewarded with a rising stock price. What matters is moving guidance from lower to higher. Cisco (CSCO) reported sales down thirteen percent from the previous year and earnings down nearly twenty percent, while its stock price has risen about fifty percent. They are hardly alone in their endeavors.
CNBC was ready for the jobs report: it stacked its Friday pre-open show with a couple of perma-bulls, one of whom explained that if you just drew a straight line under the bars on the employment report, you could see that we should reach net additions of 200,000 a month by the end of March. Brilliant analysis, wonder how much he gets paid for that. Using the same logic, we ascertained that the Dow is actually at 20,000.
Here are some things to worry about: almost no new money is going into the market, and money was pulled out of funds the last two months. Financial stocks have stopped participating in the rally. Trading is largely machine-driven. Up days have below-average volume, down days above-average. Market internals appear to be fairly weak. Gold, equities and bonds are all rising in price, which is illogical – unless you think that investing is all about chasing momentum. But if that’s the case, you’re not an investor, you’re a trader. There is too much complacency that the S&P should rise to 1200.
On the good side is that most institutions seem to have performance anxiety and are unwilling to quit the game early. They are sure that the S&P will rise to 1200. The investment alternatives to stocks are limited and cash is yielding nothing. Besides, maybe the market really will go up.
This is a market more for gamblers than investors. That’s not to say you can’t make money, but we would be careful about getting any more excited at this point. Every week we sift through the economic data and try to parse it, along with bushels of earnings calls. And every week, we come to largely the same conclusion: the economy has stopped declining, but it appears to be mostly going sideways. That’s not so bad, but it’s priced to keep going up.
Although the Wall Street Journal and Financial Times both led with baleful headlines in the aftermath of the jobs report, the traders of the day shook it off. After all, we already knew that unemployment was going past ten percent, right? And while the number was bad – a loss of (-195,000) against the consensus estimate of (-175,000) - it could have been worse. That tautology is worth a bigger bonus, we imagine.
There were some positives to the report that were eagerly passed around trading desks. The revisions to the previous months were positive, meaning that not quite as many jobs were lost as reported (we could say provisionally, as they might yet disappear again in the next benchmark revision, but that would be cynical). The direction of revisions is a fairly decent indicator, so that is a plus. The other big consolation was that temp hiring increased, which usually precedes a turn in hiring.
However, while all sea changes in employment are preceded by changes in temporary help, not all changes in temporary help end up being significant. The reason employers respond initially to changes in production by hiring more temporary workers isn’t because they read in the Journal that it’s what they’re supposed to do when the economy recovers. It’s because sometimes production reloads fizzle out, so employers stay cautious until the sustainability of any order recovery is established.
That last part isn’t inevitable. Weekly hours remained unchanged and aggregate weekly hours fell. The latter is a coincident indicator, indicating no upward hiring pressure despite the temp increase. That number was reflected in the tenth of a point increase in the manufacturing workweek. So far, the reload is quite mild.
This is how weak the job market is: despite kicking more people out of the active labor force, the unemployment rate still rose to 10.2%. The slack rate, or U-6 number that measures total slack in the labor force (unemployed plus involuntary part-timers plus marginally attached workers) rose to 17.5%, a record for the series (it only dates to the nineties).
The median length of unemployment is 18.7 weeks, compared to the previous peak of about 12 in the early eighties. The Liscio Report calculated that the chances of getting a job are the worst that they have been since World War II. It’s bad, and it’s going to get worse.
Another spin job that made us smile and shake our heads was the reporting of the weekly mortgage application survey. News crawlers boasted of the increase in the index, while Econoday eagerly stressed what an important goal refinancing was for policymakers (the refinancing index rose). Applications to purchase a home, the real focus of Fed policy, however, fell again to the lowest levels since March.
We like to be cautious about inferring too much from small samples, despite the market’s fondness for drawing a line between two data points well into the distant future. Some of the recent drop in purchase applications must be something like store traffic the day after the big clearance sale – a lot of purchasing was pulled forward, in this case by the expiring tax credit, so there was an understandable lull.
Yet despite the apparent inevitability, the drop creates additional pressure for policymakers to do something. The problem is that the longer we keep the program going –and a wider extension of the credit has now gone to the President’s desk - the more dependent the industry may become. Pulte Homes (PHM) CEO Richard Dugas talked about how nobody really wants the subsidy to be a lasting feature and what a good thing it would be for the industry to get back to a place where it’s no longer needed – but it’s still needed now, he added.
Mortgage rates will rise after the Fed stops buying agency securities. If the unemployment rate rises into the first quarter of next year, as the central bank expects, will it be any easier to withdraw the subsidy next April? One more six-month extension after that doesn’t have to be fatal, to be sure, but then one has to wonder how many politicians will want to run against extending the credit come election time next fall.
Government support of the housing market could stick around for longer than thought, especially given the size and depth of the connection with the GSE’s, Fannie (FNM) and Freddie (FRE). The support became necessary to stave off collapse, to be sure, but now the government is the lender to over eighty percent of the market, at the same time as it induces every buyer with a bonus to in effect, borrow more money from it. The banks have largely turned themselves into portals, trying to limit their involvement to the collection of processing fees only.
It isn’t a healthy situation, and we don’t think that either the Treasury or the Fed is ignorant of that fact. We can’t blame them for trying to avoid comment on the situation, either, because the truth is that nobody, your faithful correspondent included, really knows how this is all going to turn out. Pending home sales rose again, this time by 6.1% in September, but deals have had a rough time translating into sales.
Construction spending also got a spin job. The 0.8%, consensus-beating increase for September was widely publicized, but the increase was due to the August increase – also reported to have been 0.8% - being completely erased and revised away into a (–0.1)% decrease. The increase, should it survive, came in residential construction, which is good, but that category is still down over twenty-eight percent from the year before.
A great deal of excitement lit up the financial media over the latest ISM manufacturing survey, which came in at a stronger-than-expected 55.7, and its worldwide equivalent, the Global PMI (Purchasing Manager’s Index - we wish that everybody would just call it the same thing). These results are all to the good. They are also long overdue, given the record-breaking number of months that inventories have been in liquidation.
But the results only indicate change from the previous month, not absolute levels of output. We don’t know why they are being treated as stunning changes of fortune, when a rebound has been predicted since March. The back half of the rebound prediction, that it may only be enough for a refill and nothing more, is glossed over or dropped by our modern army of financial vendors who desperately need the roaring twenties to return. Sorry, did we say roaring twenties? We meant the bubble years.
The ISM non-manufacturing survey – the much larger part of the economy – also grew, but only just, with nine sectors reporting growth and seven reporting contraction. Prices jumped, which might indicate strength, but respondents seemed inclined to blame it on the falling dollar and rising commodity prices. Employment continued to contract, but there were encouraging comments coming out of the construction sector.
Factory new orders rebounded 0.9% in September after their August loss, and the durable goods portion was revised higher from the previous week. Nondefense capital goods excluding aircraft, or private business investment, recovered 1.8% after two months of losses. We may be re-entering the up-and-down pattern in new orders that was prevailing before the economy nosed-dived during last fall’s credit freeze. It’s better than the recent decline, but indicates restrained times ahead. Wholesale trade inventories fell again in September, so perhaps we’ll see some back-to-back months of improvement.
Auto sales rebounded more than expected from the big September cash-for-clunkers related drop, although they are still far below last year’s pace. Still, chain store sales reports indicated some growth from the previous month and that should lift retail sales for the month. The year-on-year store comparisons were too easy, but some commentators professed excitement anyway that luxury vendor Saks (SKS) posted a 0.7% year-on-year gain! We have to point out that it compares to a (-16.6)% decline in 2008, when stores were also caught with inventory they were forced to throw overboard in the aftermath of the Lehman tsunami.
Consumer credit fell again last month by about fifteen billion dollars, versus a consensus estimate for a loss of ten. That alone should sober up some of the silliness about the rebounding consumer, but it probably won’t be enough. Infatuation with the productivity data got much more attention. Third quarter productivity was reported to have risen over nine percent, while unit labor costs fell by more than five.
This is supposed to represent that wonderful inflection point in the economy when lean-and-mean companies start collecting big profits from their newly streamlined operations, as represented by the spike in productivity that accompanies the transition from recession to recovery. The profits will be reinvested in capital goods, or information technology, or even new hires, and as competition heats up the business cycle will begin anew.
Some flies in this year’s ointment: the increase in productivity came from running down inventories yet again, though at a slower rate, while continuing to shed workers. That’s peaked. The output data was helped by an unusually negative price deflator. That’s set to reverse. Companies aren’t using the money to increase cap ex or hiring. They put some aside for executive compensation, some for corporate finance needs, and the rest sits on the balance sheet and in bank accounts, “just in case.”
The coming week is about the exact opposite of the previous one, with a nearly empty calendar divided by the 11th of November proceedings on Wednesday. That will mean a holiday for most of Western Europe, and a bank and government holiday in the U.S: our bond markets will be closed, but the stock and futures markets will remain open.
Apart from the weekly initial claims report, there won’t be anything of real interest on the economic front until the international trade report comes out on Friday, followed later that day by the University of Michigan’s initial November report on consumer sentiment. There will still be many earnings reports, with retailers starting to show up in force. They’ll be led by Wal-Mart (WMT), scheduled to announce sales and earnings before the market opens on Thursday. With the claims report coming out the same day, that should make Thursday the day of the week.
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